Does Independent Research Mean Better Stock Picks?

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1 Page 1 of 6 Search Quotes & Research Advanced Search nmlkji Symbol(s) nmlkj Name As of Thursday, October 31, 2002 HEARD ON THE STREET Does Independent Research Mean Better Stock Picks? Heard on the Net Heard in Asia Heard in Europe ADVERTISEMENTS D E A L S Go To Deals Search Add to Personalized Home Page In Today's Paper Columnists Portfolio Setup Center Discussions Site Map Help Contact Us Log Out By ROBIN SIDEL and SUSANNE CRAIG Staff Reporters of THE WALL STREET JOURNAL Investors could soon find out how many good stock tips $1 billion will buy. The answer may come in the form of a slew of "independent" stock-research reports thrown their way as part of a settlement to resolve alleged conflicts of interest in stock analysis at the big Wall Street securities firms. Under a settlement plan now being discussed with Wall Street, regulators envision independent research being handed out alongside any reports that a Wall Street firm publishes on its investment-banking clients. As proposed, Wall Street firms would cough up as much as $1 billion over five years to pay for these additional reports. RECENT HEARDS Certain Bets May Haunt Insurers Yahoo Strategy Raises Questions 9/17 HEAVY ON THE BUY SIDE See a chart of stock-recommendation distribution as of Oct. 14. advertisement Today In: BARRON'S Your Service Give a perfect gift The Online Journal OPEN: The Small Business NetworkSM. Go! Get 25 commissionfree trades! Trade 5 Lind- Waldock. Click Now! IBM Fusion Webisodes The Smart Marketing Report from DoubleClick But first things first: What qualifies as independent research? And does independent research mean more insightful research -- that is, does it mean better stock picks? As it turns out, there aren't clear-cut answers to these questions. For example, while Wall Street firms have been criticized in the past for offering too many "buy" and too few "sell" recommendations, the mix has changed in the current environment. They are making as many "sell" recommendations these days as many independent outfits. Moreover, reviews of their stock picks over the past 12 months show that the returns of hypothetical portfolios of some Wall Street firms compare favorably with the returns investors would have gotten from following the advice of the independents. ANALYZING THE ANALYSTS See complete coverage of the heightened scrutiny of stock analysts at wsj.com/analysts Pitt and Spitzer Butted Heads Citigroup Separates Operations Citigroup Calls On Tough Outsider Salomon Name to Take a Back Seat Stock Advice You Can Trust? SEARCH HEARDS Find Heard articles containing the following words: Limit search to: All Heard

2 Page 2 of 6 In general, as it is being bandied about in terms of the Wall Street settlement, an independent research firm is one that is free of the investment-banking operations that present the most-obvious conflicts of interest. As s released by regulators in recent months have shown, Wall Street analysts on numerous occasions publicly touted Internet stocks, under pressure from investment-banking colleagues worried about offending banking clients, even as they privately disparaged some of them. In other cases, clients have directly pressured analysts for positive coverage. These conflicts most typically have surfaced at what are dubbed "sell-side" firms, Wall Street shops where stockbrokers pitch securities to investors. This is in contrast to "buy-side" research, which is produced by analysts at mutual-fund firms, hedge funds and investment-trust departments, mostly for internal use. Independent firms, by contrast, don't offer investment-banking services and typically sell their research to professional investors, though some, like Value Line Inc. and Morningstar Inc., are best known for selling reports to individual investors. COMPANIES Value Line Inc. (VALU) Dow Jones, Reuters This independence can make it easier for Financial Services & Insurance analysts to call them as they see them. For example, Morningstar went bearish with the equivalent of a "sell" rating on VeriSign Inc. in December 2001, when the stock was trading at $42. Around the same time, Credit Suisse First Boston, whose investment bankers had recently advised VeriSign in an acquisition, gave it a "strong buy" and a $60 price target. It never got there, and Wednesday the shares were trading up five cents at $8 on the Nasdaq Stock Market. But a lack of an investment-banking department doesn't necessarily mean that a firm is always right -- or is free of potential conflicts of interest. For example, Sanford C. Bernstein & Co. LLC, one of the largest so-called independent research firms, is a unit of big mutual-fund group Alliance Capital Management Holding LP. Prudential Financial Inc., which ditched most of its investment-banking unit in late 2000, likewise is a big mutual-fund operator. Although Bernstein and Prudential are structured so that the two businesses operate separately, some skeptics fret that Bernstein and Prudential analysts could have an incentive to promote stocks that the mutual funds own; after all, the big Wall Street firms have long contended that their investment banking and research functions are separate. Bernstein and Prudential maintain that the firewall between the businesses is thick. Another relevant distinction between Wall Street and independent players: Much of the research bill at the sell-side firms is footed by the investment-banking departments. For the independent, research typically is sold as part of "soft dollar" arrangements -- a common practice in which investors get analysis in return for placing their trades through the firm's brokerage desk Alliance Capital Management Holding L.P. (AC) Prudential Financial Inc. (PRU) Lehman Brothers Holdings Inc. (LEH) Citigroup Inc. (C) RELATED INDUSTRIES Banking * At Market Close

3 Page 3 of 6 For now, it's unclear which independent firms would get a chunk of the $1 billion. Under the regulators' plan, a panel to be selected by state regulators and the Securities and Exchange Commission would choose 10 to 20 providers of independent research each year. Among criteria to be considered: the number of stocks covered, quality of the analysis and experience of the analysts who do the actual stock picking. The panel could have its work cut out for it, because quality is hard to measure. Should the panel focus on how well the firms' stock picks performed over the past 12 months -- or the past five years? Should it look at the five largest stocks covered by a firm? Or should it require a minimum number of stocks in its universe, which would eliminate a lot of boutiques that otherwise have good reputations? Should it focus on the willingness of firms to aggressively issue "sell" ratings? The upshot: Independent firms are all over the board, and many actually don't have better track records than Wall Street. Just as independent movie-makers have their share of flops -- for every "My Big Fat Greek Wedding," there are plenty of movies that don't make it to the theater -- the same can be said of independent stock research. In other words, investors shouldn't automatically assume that independence equals insight. Data from Investars, a Hoboken, N.J., service that tracks the performance of analysts' stock picks, indicate that six of the better-known independent research firms, on average, outperformed a half-dozen Wall Street firms over the past 12 months -- but largely because one of the independents scored a striking 36% portfolio gain. The independent firms logged a 3.3% portfolio decline in the 12 months ended Oct. 29, compared with a 6.2% drop for the Wall Street firms. Bernstein logged in at a negative 8.15%, and Prudential, negative 5.4%. A Prudential spokesman couldn't immediately confirm the results, while Bernstein wasn't available to comment. In the same period, the Standard & Poor's 500-stock index dropped 18.2%. The home-run-hitting firm, Avalon Research Group Inc. of Boca Raton, Fla., placed many timely "sell" recommendations on stocks, in various sectors, calls that were aided by the declining stock market. Founded in 1995 by two investors who favored making bearish bets on stocks, Avalon now has 14 analysts who search for stocks in which they can take a viewpoint that contradicts the prevailing Wall Street opinion. Although the company may issue recommendations on about 100 stocks a year, it jumps in and out of coverage. As of Wednesday, Avalon's universe of recommendations included seven "buys" and 28 "sells." "Our stuff isn't for the faint of heart," concedes Michael Margolies, chief executive of Avalon, adding "there's no value in Avalon research being the 24th 'buy' recommendation on a stock." But investors probably won't see Avalon's research being offered by Wall Street as part of the settlement, because Mr. Margolies says that such broad distribution "would cheapen my product. We're exclusive, we're proprietary and we keep our customer base under control." Meanwhile, a quick-and-dirty review of current stock recommendations reveals that Lehman Brothers Holdings Inc. and Citigroup Inc.'s Salomon Smith Barney unit currently have more "sell" ratings on their universe of stocks than independents Fulcrum Research Group, Morningstar, Bernstein and Prudential, according to data provider Thomson First Call and the firms themselves. Lehman has 26% at "sell," while Salomon has 27%. But Bernstein has just 6%, according to Thomson First Call.

4 Page 4 of 6 Some independents target specific sectors, and some follow just a handful of stocks. Those covering the biggest universes include Prudential, Morningstar and Value Line, though the hundreds they each monitor pale beside the 1,000 or more covered at the biggest Wall Street firms. At 71 years old, Value Line is a granddaddy among the independents, its research for decades available in public libraries, while many, like Avalon, were born of the recent bull market. Many independent firms prepare the sort of company reports that investors are accustomed to from Wall Street, with emphasis on earnings and other financial-performance benchmarks. Beyond this research, some independents offer highly specialized reports and data crunching, tailored to the needs of institutional clients; some of this fetches thousands of dollars a month. "We view independent research very highly," says Bill Stromberg, director of equity research at T. Rowe Price, noting that the Baltimore mutual-fund group's analysts and portfolio managers use material from some 20 independent firms. In particular, he says, T. Rowe Price favors Sidoti & Co., a New York research firm that has 30 analysts and covers about 200 small companies. "I rarely ever get an idea from Wall Street," says Neil Weisman, general partner at Chilmark 21st Century Capital, a New York hedge fund. Mr. Weisman, a bargain-hunting value investor, looks to boutiques like Vogel & Associates, New York, for "thought-provoking ideas." -- Randall Smith contributed to this article. Return to top. Write to Robin Sidel at robin.sidel@wsj.com and Susanne Craig at susanne.craig@wsj.com Updated October 31, 2002

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