Is Wall Street ‘Full of Bull’?

A well-respected analyst for 32 years, Stephen McClellan describes how analysts’ advice is biased and misleading for individual investors

by Ben Steverman

Stephen McClellan is biting the hand that fed him for 32 years.

A top-ranked analyst at Salomon Brothers and Merrill Lynch (MER), McClellan was one of the first to cover the booming computer industry. In addition to being well-respected, he was one of the longest-serving equity analysts on Wall Street, with a career stretching from 1971 to 2003.

Now, the retired 65-year-old number cruncher is saying what he really thinks about Wall Street. In his new book, Full of Bull: Do What Wall Street Does, Not What It Says, to Make Money in the Market (FT Press, 2007, $22.99), McClellan, admits that price targets are “fiction,” and buy/sell/hold ratings aren’t taken seriously by professional investors. Analysts spend perhaps only 20% of their time on research and the rest on marketing and other tasks, he says. They create sophisticated computer programs to track a company’s earnings, revenue, and cash flow in close detail. But the results are “not accurate at all,” he says. In fact, analysts often miss big trends and have a terrible record as stockpickers.

Stiff Penalties
Research isn’t written for retail investors, but for institutions. Those institutions, including mutual funds and hedge funds, have far too much influence over an analyst’s research, McClellan says. Companies and executives are also too good at manipulating analysts.

Even more blatant biases were exposed as part of the 2002-03 investigation by the New York State Attorney General and securities regulators, which led to the Global Settlement of Conflicts of Interest Between Research & Investment Banking that required 10 of the nation’s top investment banks to pay $1.4 billion in penalties and restitution to harmed investors, including money for investor education and independent research.

The research settlement may have pushed apart investment banking and research, but it left in place lots of other conflicts of interests, McClellan says. Plus, the settlement’s money for research—money that is slated to run out in 2009—hasn’t improved its usefulness for investors. By giving research away, Wall Street has diluted its quality, he argues.

Exposing the Code
McClellan says that when he retired, he began to realize how naive individual investors “take Wall Street literally.” When analysts rate a stock as a buy and expect it to rise 20% in the next six months, many individual investors actually believe them.

“All of us insiders know the code,” McClellan said in an interview with BusinessWeek. “But all the outsiders don’t.”

The book is designed to “expose the puzzling, deceptive, conflicted behavior of Wall Street that so disadvantages individual investors,” he writes. It’s not that Wall Street intentionally tries to cheat and deceive individual investors, he says. Rather, investors are at a disadvantage because so many other interests—those of companies, institutional investors, and the brokerage houses themselves—come before their own.

Paid Salesmen
“Wall Street is not suited to be an investment manager, financial adviser, or stock selector,” he writes. “In fact, these services that it purports to offer are a conflict of interest with [its] bedrock brokerage and banking functions.”

Suppose your stock broker recommends defense industry stocks. First, realize that your broker is not an expert financial adviser but a salesman paid to sell you a product, McClellan says. Second, understand that the broker is probably basing that recommendation on a stale analyst note and its advice is probably already reflected in the price of stocks.

Third, there are a lot of biases included in this recommendation. Analysts rarely look past the next six months, for example, which is a bad approach for individual investors trying to build wealth over the long term. Analysts are also biased toward large companies. Institutional investors like big, heavily traded names even if, McClellan writes, “individuals can benefit by making an astute, early investment in smaller companies not already picked over by Wall Street.”

McClellan has proposals for how he would reform research on Wall Street. He would make analysts far more independent, so they’re not “embedded in the bowels of a brokerage firm,” with all the inherent conflicts of interest.

But McClellan’s book’s main purpose isn’t to shame Wall Street into changing its ways. Rather, he says he wants to help individual investors profit despite their disadvantages. Research can be valuable because it gives investors lots of detail on companies and their industries. Absorb that information, McClellan says, but disregard analysts’ conclusions and recommendations.

“The individual has advantages,” McClellan says, especially the ability to see “the big picture trends.” By contrast, he writes, analysts “may be good at evaluating the trees, but they fail to have enough vision to see the forest.”

Size Up the Boss
McClellan says he has become a better investor since he retired from Wall Street. In his book, he offers investment advice based on his three decades as an analyst. For example, investors should closely evaluate a company’s CEO before they invest, he says. He describes various types of executives he has met, from the “visionary leader” to “techy geeks who know their stuff” to “promotional hypesters without substance.”

Since writing Full of Bull last year, McClellan says he’s disturbed by the wave of trouble heading toward the U.S. economy. It’s not just the credit crisis and the housing slowdown that worries him, but also the weak dollar, the government deficit, the decline in corporate earnings, the inflation, and a troubling Federal Reserve response to it all.

McClellan warns that stock market slumps often last two or three years. “This could be one of the biggest bear markets we’ve had in 30 or 40 years,” he says. “Be cautious and careful.”

Still, McClellan says, Wall Street remains “eternally bullish,” predicting the economy and stock market could bounce back in the second half of the year. That’s because analysts don’t want to scare investors away from trading and building portfolios, no matter how frightening the news might be.


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