Do Stock Ratings Still Matter?

On Oct. 31, 2007, Meredith Whitney argued Citigroup would cut its dividend and slapped an "underperform" on the stock. The call made bundles of money for clients who acted on her advice.

Whitney, who was at CIBC World Markets at the time of the Citigroup call, has since struck out on her own and founded Meredith Whitney Advisory Group.

Meredith Whitney
Meredith Whitney

One investor complained she charges way too much for her research — $500,000 per year was what her firm quoted the investor. Another contends Whitney's price has come way down — to $100,000. (A call to Whitney from TheStreet was not returned.)

"Ultimately it's all negotiable," says Gary Townsend, portfolio manager at Hill-Townsend Capital and himself a former sell-side analyst.

"Meredith has established a certain reputation, but you better make the right calls, because if you don't, I think you will lose your customers," he explains.

"If you're charging $500,000 there has to be something especially insightful that's going to justify that type of expenditure and the markets don't give you the opportunity every year to say Citi isn't going to pay a dividend."

It's no secret that a lot of the glamour and prestige has gone out of being a Wall Street analyst, not to mention the shrinking paycheck.

The big change to the profession came in 2003, after regulators led by then-New York Attorney General Elliot Spitzer unearthed e-mail messages that showed analysts privately trashing stocks they publicly recommended so the investment banks could earn fees helping companies raise money in the capital markets.

As part of the eventual settlement with regulators, most major U.S. securities firms, including Citigroup, Goldman Sachs, JPMorgan Chase and Morgan Stanley were required to sever the ties between research and investment banking.

That made research a lot less lucrative, and while it was supposed to make it more objective, Wall Street research remains overwhelmingly bullish, with nearly every analyst showing far more "buy" recommendations than "sells."

That is understandable to Derek Pilecki, portfolio manager of hedge fund Gator Capital Management. Pilecki argues bullish calls are far more likely to generate trading commissions — the way many money managers pay for research — than bearish ones, since many investors don't short stocks.

There is also the fact that analysts who are negative on a company may get the stiff arm from top executives.

"We're all well aware of those conflicts," Pilecki says.

One recent example of a bearish analyst getting shut out of the information loop was CLSA analyst Mike Mayo, who couldn't get a meeting with Citigroup for two years. Eventually, after he made a very public stink, he got a chance to sit down with bank management in October. (Check out Mike Mayo's bank calls in a March 3, 2011 interview with CNBC.)

Few analysts have as much clout as Mayo, and as a result are presumably less likely to risk offending top managers of companies they follow.

That can lead to some fairly toothless research. Townsend says one stock he follows, XL Group, has gone from $80 down to $3 and back up into the twenties, while an analyst who has covered it that whole time hasn't changed his "market perform" rating on the stock.

Townsend declined to name the analyst.

"It leaves you kind of wondering why they're covering stocks at all," Townsend says.

Still, none of the investors interviewed by TheStreet would go so far as to say they have no use for Wall Street research. Not one says they buy or sell a stock based on an analyst's call, however.

Tom Brown of Second Curve Capital, another Wall Street analyst-turned-investor, says though in general he has little use for sell-side research, "maybe five times a year" he will receive a report demonstrating exceptional in-depth analysis. A recent example he cites is "an in-depth look at Bank of America's funding, the pressure on their margin and how it could be alleviated," from Sanford Bernstein analyst John McDonald.

Brown says he will pay for high quality research like that by doing more trading with Sanford Bernstein for a time — generating commissions for the firm.

He also values "the occasional-but-rare deep dive" into a company, or in the case of large companies, a line of business.

"You wish you saw more of that, but you just don't," he says.

Another one of the main things that make analysts valuable to Brown and other investors is their access to company management — the same thing that makes the analysts fearful of criticizing the companies they follow.

That access can take the form of, as Brown puts it, "I just was at company XYZ, and here's what I discovered."

Analysts can also be useful for setting up face-to-face meetings between management and investors. That can be especially valuable for hedge funds, which are shunned by certain companies who do not want what they perceive as "fast money" in their stock.

"Some companies, if you call them up and say I'm from this hedge fund, they don't want to talk with you, whereas if you go through a stock brokerage firm and they set up a dinner and they invite 20 clients to the dinner, a hedge fund can be on that list," says hedge fund manager Pilecki.

Peter Kovalski, analyst and portfolio manager at Alpine Funds and yet another former sell-side analyst, says he often values an in-depth analysis of a particular issue such as a new accounting or regulatory mandate.

But explaining the long-range impact to earnings from new rule is a very different skill from knowing when to enter or exit a stock.

"It's hard to find an analyst who's good at both," Kovalski says.

Given how little these investors allow research to dictate when they pull the trigger on a stock, it is surprising that analysts still move companies' shares on a regular basis with their research.

Kovalski suspects investors who allow research calls to dictate their moves may be larger, more-diversified funds, or investors who have more of a momentum-based investment philosophy than those interviewed for this article.

That suggests the best way to make use of Wall Street research may be to do the opposite of whatever is recommended. If only investing were that simple!


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