Are You being Cheated by Brokerages

Thursday, April 24, 2008 | | |

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, 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.