Stock sting

Brokers may be wrongly leading clients towards stocks underwritten by their own firms, writes Roger Trapp

Anybody who has even dabbled in shares will know that the stock market is not the straightforward place it is made out to be. The value - or accuracy - of market information can depend heavily on who is providing it, and when.

Many may accept that this is simply the way of the world, but two US academics have published a study that could have important implications for the way in which investment banks bring companies to the market.

Roni Michaely, of Cornell University's Johnson Graduate School of Management, and Kent Womack, of Dartmouth University's Amos Tuck School of Business Administration, claim that their work demonstrates "significant evidence of bias - and possible conflict of interest" between analysts' responsibility to investing clients and their incentive to market stocks underwritten by their own firms. "Contrary to the conventional wisdom, we found that the market doesn't come close to recognising the full extent of this bias," says Mr Michaely.

The study of US initial public offerings (IPOs) was inspired by the somewhat lacklustre performance of shares in the Snapple fruit drink company after it was brought to the market five years ago. The two researchers compared the investment recommendations made by underwriters and non-underwriters of 391 companies that conducted IPOs in the 1990-91 period, and tracked performance for up to two years after the offering date.

"We found that not only were analysts' recommendations biased in favour of stocks of their firm's IPO clients, but stocks of companies which were recommended only by analysts from the underwriting firms were terrible performers," says Mr Womack.

As early as six months after the date of the offer, IPOs recommended only by their own underwriters were underperforming the group recommended only by non-underwriters. After two years, the group that had been recommended by non-underwriters was outperforming the other group by more than 55 per cent.

Nor is the phenomenon confined to a small group of investment banks, according to Mr Michaely, who was recently in London discussing the research with academics and practitioners. "For 12 of the 14 major brokers making buy recommendations for both their own underwriting clients and non-clients, their batting average was much better on their non-client recommendations."

The British authorities do not believe that the problem exists on such a scale on this side of the Atlantic, but it is acknowledged that Big Bang 10 years ago created the environment for conflicts of interest, and the issue is kept under review.

The authors of the paper, Conflict of Interest and the Credibility of Underwriter Analyst Recommendations, suggest that there are two possible explanations for what is going on. Either the underwriting analysts genuinely believe that the offerings underwritten by their firms are better than those supported by other banks, and make their forecasts based on an "insider's view", or they know that they are misleading the public but do so anyway - because they have been directed to, or because it is good for their salaries.

Either way, Michaely and Womack believe that the findings raise important questions about a need for additional regulations to protect investors, as well as the structure of the investment banking industry in the United States.

On his London visit, Mr Michaely reiterated his belief in the free market economy, but stressed that where the market did not work - as appeared to be the situation here - further safeguards were needed. He pointed out that the findings cast doubt on the case for lifting restrictions on investment banking in the US, and therefore the building campaign for repeal of the Glass-Steagal Act, which separates commercial and investment banking.

But he also believes that the Securities and Exchange Commission, the lead regulator of the US markets, should look at extending the period - currently 25 days - during which an underwriter cannot boost the stock, and require new issues to carry a more obvious "health warning".

"The investing public is not fully protected," says Mr Michaely. "Investors do not understand the extent of this bias; the market does not adequately correct for it. It's time to consider whether to restrict, or at least monitor more closely, how analysts handle IPOs underwritten by their firm."

Moreover, the findings clearly showed that, even in a restricted environment, "there is still bias and, quite possibly, conflict of interest"n