Schwab shares the advice chip

The new tidal wave of proprietary advice coming from Charles Schwab & Co. Inc. now is washing onto the laptops of its 6,000 independent advisers.

Some financial advisers, however, are underwhelmed.

The San Francisco-based broker reported last week that its computer-generated action ratings on 3,300 stocks are now freely available on its Schwab Institutional website to anyone with a password.

Schwab already uses its Schwab Equity Ratings to arm its staff of brokers with the authority to select individual stocks at its Private Client offices.

The power of the ratings also emboldened Schwab earlier this summer to begin rolling out a first-ever family of actively managed funds (InvestmentNews, Aug. 12).

Now the company is telling advisers that they too can wield that Pentium power and – for the first time – say it has the Schwab seal of approval.

But in the complex collective-bargaining-style relationship between Schwab and its advisers, giving the ratings system to advisers is also living by union rules.

“This is an example of where we’re taking services we’ve offered to retail clients through to our advisers,” says Liz Fanlo, vice president of Schwab Institutional.

Some discomfort

Although Schwab’s independent advisers have accepted the rollout of Schwab’s Private Client offices this year, many remain uneasy about them.

And some advisers feel uncomfortable with the newfangled ratings themselves.

Scott Van Den Berg, vice president of Century Management in Austin, Texas, a Schwab-affiliated adviser with $750 million under management, says that “independent thinking” is the only useful mode of achieving superior returns.

“We wouldn’t use one piece of it,” he says. “Everybody tries to automate picking stocks, and that kind of stuff doesn’t beat the markets over the long term.”

Mr. Van Den Berg is an elite stock picker whose portfolios were up 6.6% for the first half and 26.7% for the three-year period ended June 30. His firm has recorded one down year in the past 25.

Yet Judy Shine, principal of Shine Investment Advisory Services Inc. in Greenwood Village, Colo., which manages $275 million, says Schwab Equity Ratings has its place with independent advisers, especially when you look beyond the distilled ratings. She says the ratings are more detailed and presentable than the Standard & Poor’s research she pays for.

“It gives you the good, the bad and the ugly, and you can talk about it,” she says. “It’s great for people with a lot of stock in their own company.”

Still, Ms. Shine says she knows the perils of ratings.

“Morningstar rated mutual funds one, two, three, four, five,” she says, in a reference to the Chicago fund-rating firm’s star system. “All you had to do was buy fives. It didn’t work.”

But advisers are free to take the best and leave the rest, Ms. Fanlo says.

`No one approach’

“We know there’s no one approach to equity analysis,” she says. “Our clients have told us that over and over.”

Schwab Equity Ratings, which are generated by a computer, are expected to serve two key functions for advisers, Ms. Fanlo adds. They bring an unbiased objective filter to the firm’s current stock-screening technology that relies heavily on Goldman Sachs and Thomson First Call.

The ratings also are expected to bolster the way advisers keep on top of what stocks to sell – a glaring weakness in most research systems developed to date. Even after the past year’s upheavals, most Wall Street firms issue a paucity of “sell” recommendations.

Because Schwab’s system grades stocks on a bell curve, “buy” and “sell” recommendations appear in equal measure.

At any given time, 30% of all rated stocks are afforded a D or F, which is Schwab’s “sell” equivalent. The top 30% are rated A and B, the equivalent of a “buy” rating. The remaining 40% are Cs, in effect “holds.”

The other edge provided by the system is its tirelessness. It generates weekly updates in the ratings of the 3,300 stocks, according to James Burton, Schwab’s vice president of investment advice and products.

Still, Mr. Burton thinks that in the longer term, advisers may be pleasantly surprised at how well the ratings serve as predictors of stock value. He says the approach uses a whopping 24 inputs that are “style neutral” in that they draw from both the momentum-based world of growth managers and the fundamental approach of value investors.

The momentum component ironically includes the views of Wall Street analysts and short-seller sentiment. The valuation component looks at the stock price versus free cash flow.

“It’s also important what we didn’t include,” Mr. Burton says. “We discarded long-term earnings forecasts. We have found that it’s unpredictable and unknowable.”

He says advisers may also find it useful that four subratings go into each final grade. Those include A to F ratings for fundamentals, valuation, risk and momentum.

So which advisers are going to take advice from the Schwab machine?

Adrian Moravcsik, senior vice president and principal of Stein Roe Investment Counsel LLC, a firm in San Francisco with $8 billion in assets, says it won’t use the ratings, because of its in-house research capability.

Thinking small

But Mr. Moravcsik says that firms with between $50 million and $300 million in assets find the ratings useful. Those firms often don’t have the cash to plow back into hiring their own analysts.

Mr. Van Den Berg agrees that that subsegment will be drawn to the ratings, but he takes a dimmer view of their motivations.

“It’s easier to be a planning machine and a marketing machine rather than do the research,” he says. “For those firms that don’t want to spend the time, this could be a big help.”

Ms. Fanlo says Schwab’s advisers already have shown how much they depend on the company for securities research. At least 3,300 Schwab advisers use Schwab Institutional’s Research Workstation each month.

Quantitative research such as Schwab’s has its supporters who love its simplicity and objectivity. The detractors hate that a computer can’t tell a Krispy Kreme doughnut from a Kmart cruller.

But no one can question Schwab’s impeccable timing.

“I wish I could say we had the nimbleness and foresight to see the troubles of Wall Street this spring,” Mr. Burton says.