Experts need to recover objectivity

IN the past decade, the objectivity of sell-side research has been hopelessly compromised. The Enron debacle focused attention on the problem, although it had been noticeable in many ways for some time.

Many analysts wrote glowingly about companies with no earnings, high cash-burn rates and shares selling at inflated prices relative to sales volume and profit prospects. In place of rigorous analyses of companies and industries came reports that parroted the views of corporate management or relied on historical evaluation norms.

Preserving the objectivity of research was always a priority when I was at Salomon and managed for many years a large research group that grew to more than 450 professionals by the time I left in 1988. In those years, I was never urged to modify my views to conform with the immediate underwriting or trading activities of the firm - and I know of no researcher in my department who was asked to change analytical conclusions.

Sure, there were occasional complaints from trading and underwriting desks because of one or another view I expressed publicly (usually in written form) but, as head of research, I was in a unique position to fend off any criticism. I was a senior partner and a member of the firm's executive committee, where no member ever asked that research accommodate the underwriting or trading activity.

The attitude of "hands-off" research changed during my closing years at Salomon. The structure of senior management was changed. That authority was shifted from the executive committee to an office of the chairman, from which I was excluded.

These changes removed me from a position where I could defend the objectivity of research at the highest level. It also suggested to me that the next head of research would not be a member of senior management. I resigned and, unfortunately, my conclusions were proved right.

Over the years, official warnings were disregarded. In a speech before the Economic Club in October 1999, Arthur Levitt, chairman of the Securities and Exchange Commission, said: "Our review of the relationship between companies and the analysts who follow them indicates that analysts, all too often, are falling off that tightrope on the side of protecting the business relationship."

The scope of the problem is now vast. Public attention is most focused on the role sell-side analysts play in attracting new issues of securities. Hardly anyone seems concerned about the potential for the sell-side firm to front-run trading positions on the basis of soon-to-be-released research reports. Traders have many opportunities to ferret out a change in the analyst's view or to learn of the timing of press releases.

I believe these problems facing the sell-side analyst can at best be mitigated. My experience strongly suggests that the head of research should be a member of senior management. This would establish his authority to deal with research issues at the highest level.

The relationship of the sell-side institution with the company being analysed should be stated in the report up front. Company reports should also include a comparison of real performance with previous projections. I question the ability of analysts to project with reasonable accuracy the future price of a stock and would prefer that projections be limited to earnings and industry developments.

Last, I strongly recommend that analysts focus much more on the financial strength of corporations by delving into accounting practices, the valuation of assets, contingent liabilities and other off-balance-sheet activities.

The logical solution to this conflict is for sell-side institutions to provide no research reports to clients. Research would serve only an in-house function by providing analyses that would help the institution assess the merits of the securities it is underwriting and trading. Institutional investors and independent research firms would then fill the gap.

Presumably this would lower the cost of research at sell-side firms, which would lower trading and underwriting costs, and offset a healthy portion of the increased research costs on the buy side. - (Financial Times Service)

The writer is president of Henry Kaufman & Company, an economic and financial consulting firm, and author of On Money and Markets, A Wall Street Memoir