By Greg Peel
The Australian Securities and Investment Commission has been charged with the task of reassessing and consolidating investment advisory compliance rules in the wake of the Global Financial Crisis. A similar process is being carried out in all developed economies as a result of a G20 finance ministers' commitment to move toward more regulatory consistency across the globe.
Areas of focus include the problem of “too big to fail” in regard to financial institutions, the problem of opaque over-the-counter financial derivatives, and the issue of government guarantees of bank deposits. But also high on the agenda is a need for further protection for the retail investor.
Last year ASIC commissioned a survey of Australian retail investors, focusing particular attention to those hard hit by the GFC and its subsequent impact on financial markets. The burgeoning self-managed superannuation fund pool of investors was an obvious place to start.
ASIC has been receiving details of the survey over the first quarter 2010, and has this morning released a memorandum citing one particular complaint from investors that came up in the survey time and time again. Investors find stock broker recommendations confusing and misleading, and in many cases money had been lost by following recommendations closely.
“Many participants were incensed,” suggested ASIC spokesperson April Tromper, “that some stocks in their portfolios were still under 'Buy' ratings with brokers even as they lost up to 60% in value. Many claimed to be confused by the meaning of 'Buy', 'Outperform' and other typical ratings and how they differed from one another.
“Most of all it seemed,” said Tromper, “that investors could not understand why one broker can say 'Buy' when another says 'Sell'”.
This is hardly news to FNArena, which often fields email inquiries of exactly the same nature.
There are three major ratings scales used by brokers in Australia as well as across the world, being Buy, Hold or Sell; Outperform, Neutral or Underperform; and Overweight, Neutral or Underweight. In the last case, Equal-Weight can also be used in place of Neutral. In some cases, variations of combinations are used.
To further confuse the issue, some brokers stretch their ratings to a total of five, thus including mid-tier ratings such as Accumulate or Reduce.
In each case, it is the intention of the broker, or stock analyst, to convey the same meaning. Buy, Outperform or Overweight all mean investors should hold a greater proportion of the stock in question than its index weighting suggests. Sell, Underperform or Underweight means hold less, and Hold, Neutral or Equal-Weight means hold the equivalent index weighting.
However, the average small investor does not hold a portfolio equivalent to, for example, the ASX 200, upon which these ratings are based.
It becomes more confusing when the concept of target prices are introduced.
“Yes it's true that sometimes we can apply an Overweight rating to a stock even when the trading price has already exceeded our target price,” said one analyst from a major house I spoke to this morning, who for obvious reasons wished to remain anonymous. “Occasionally we even confuse our institutional clients”.
It would be a littler simpler if all brokers stuck to one popular formula – one in which a Buy rating was applied if the traded price was below the broker's target price, Sell if above, and Hold if on or near. This is the usual process, and indeed some brokers trigger ratings changes by a purely objective price formula rather than any form of subjective view.
But this still does not resolve the issue of how a retail investor – the numbers of which were very strong ahead of the GFC in proportional share holding terms – is meant to resolve the different ratings used by brokers, or the instances in which one broker says Buy and another Sell for the same stock at the same time.
The proposal put forward by ASIC this morning is to standardise all broker ratings for the benefit of the retail investment community. ASIC was not yet specific on which system would be enforced, although the early suggestion is that Buy, Hold, Sell is the simplest to appreciate.
Furthermore, stock brokers would be required to register their ratings changes with ASIC ahead of the release of research reports and provide justification for that change by means of a new compliance document currently being drawn up by the regulator.
In a move that will most unnerve the sell-side community, ASIC also intends to mark those ratings changes against prevailing trading prices and track broker performances. In the case, for example, of a broker maintaining a Buy rating on a stock that is continuing to lose value, ASIC intends to take some form of punitive action.
“The system will be akin to the 'speeding ticket' system in use for listed companies,” explained Tromper, “in which companies are obliged to justify unusual stock prices movements and can be fined for breaches of disclosure regulations. Brokers unable to justify their stock ratings will also be subject to potential fines and possible loss of trading licence”.
ASIC further intends to issue “please explain” notices to brokers whose ratings on a particular stock do not match consensus, such as a broker who publishes a Sell rating when the great majority of peers is recommending Buy.
“It is a lack of consensus that confuses many retail investors,” Tromper suggests, “and ASIC believes it is in the interest of the investment community to increase compliance among the broking industry”.
The response to this memorandum from FNArena's contact at the major broking house cannot be printed, but suffice to say ASIC has a fight on its hands if it is to see these new rules passed into legislation. However, we are already aware that Australian banks are currently in fear of upsetting the government in an election year lest they incur the wrath of those campaigning. It would be popular with the electorate if policies were put forward for much greater bank regulation.
To that end, the broking community might also be best served by ceding to ASIC's wishes.
