Wall Steet’s other analyst flap

The other shoe has dropped in an arbitration complaint involving a high-profile Internet analyst – and landed squarely on Merrill Lynch & Co. Inc.’s assets.

But critics say Wall Street faces an even broader problem with analysts – the way they more often ignore scores of companies that sell stock to the public.

The drought is so bad, some smaller companies have started paying researchers to issue a report on them. The industry puts no stock in that practice, but investors may be none the wiser.

“We’ve taken the position that there’s not much credibility in that,” says Louis Thompson, president and CEO of the National Investor Relations Institute in Vienna, Va. “But there are definitely companies that are doing it.”

Combine the questionable veracity of Wall Street research with the high number of companies that get no coverage, and critics say investors are being cheated in more ways than one.

“It means less efficient markets, more blindside surprises and blowups, and overall less economic growth,” says Scott Cleland, CEO of the Precursor Group, an independent research firm in Washington.

“Capital markets require information to function,” he says. “It’s like the light is not on.”

growing backlash

The arbitration complaint highlighted the growing backlash against Wall Street analysts. The nation’s largest brokerage company agreed last week to pay $400,000 to resolve charges brought by New York pediatrician Debases Kanjilal, who had sought $10.8 million (InvestmentNews, June 18).

The case could “open the floodgates” to other claims, says Kanjilal’s lawyer Jacob Zamansky.

But Merrill spokesman Joseph Cohen says the matter was “settled to avoid the further distraction and expense of protracted litigation.” The company admitted no wrongdoing.

On the flip side of the issue, critics say brokerage firms have been slashing research coverage unless the potential exists to generate trading commissions or an investment banking relationship with the covered company.

In the Kanjilal case, Merrill Lynch Internet analyst Henry Blodget was accused of issuing bullish reports on Infospace Inc. without disclosing that Merrill’s investment banking arm had a lucrative financial underwriting deal that involved the Bellevue, Wash., telecommunications company.

In contrast, small-cap companies typically get left out of the loop.

“It generally costs … between $100,000 and $200,000 per stock to provide research coverage,” says Peter Sidoti, founder and CEO of independent research firm Sidoti & Co. in New York.

“It’s just not economic for brokerage houses to cover small-cap firms,” Mr. Sidoti says.

For instance, pharmaceutical giant Merck & Co. Inc., with a market cap of $155 billion, has roughly 30 analysts covering it.

In contrast, J.M. Smucker Co., with a market cap of $644 million, has just one analyst covering it: Sidoti & Co., which sells its research to 170 institutional investors.

Sidoti is one of the independent outfits that focus on companies with a market cap of $1.5 billion or less.

Even then, getting coverage by a research boutique means that the information is reaching a limited audience.

“No one is minding the store or watching those other companies,” says Mr. Cleland. “It means investors in those companies are flying blind.”

Since at least 1998, the number of companies that get analyst coverage has been declining steadily, according to data provided by I/B/E/S International Inc., a Thomson Financial company in New York.

As of last week, 4,240 public companies were getting covered by at least one analyst, down from 5,263 at the end of 1998. That’s a 19.5% drop.

In fairness, the number of public companies listed on the major U.S. exchanges shrank to 7,964 during the same period, from 8,952, but at a notably slower rate: 11%.

Overall, it means 46.5% of listed companies get no coverage, up from 41% in 1998.

Some point to Regulation Fair Disclosure as a way to increase the flow of information, with or without analyst coverage.

“Wall Street historically has served as the emissary of corporate news for investors,” says Burton Rice, executive vice president of Corporate Communications Incorporate, an investor relations firm in Nashville, Tenn.

“And while that’s contracting, there’s a much broader avenue for corporations to go directly to investors now,” Mr. Rice says.

He believes that analyst coverage will undergo a dramatic shift, thanks partly to the scrutiny on their research, the likely change in compensation structure and also Regulation FD’s green light for companies to disclose more information straight to investors than they ever did in the past.

“`Thou shalt not forecast,’ used to be [in needlepoint] on CEOs’ walls,” says Mr. Rice. “That’s been torn down.”

Maureen McNichols, a professor at Stanford University’s Graduate School of Business who has researched analyst recommendations, is surprised by Merrill’s speedy settlement.

“I have feeling in this case they really did settle because they didn’t want the nuisance value of it. But on the other hand, I think many investment banks are concerned about this because it will encourage other people to file suit.”