Richard Jenrette, who was born six months before the Great Crash of 1929, realized that the stock market was undergoing a seismic shift when he and two Harvard Business School classmates, William Donaldson and Dan Lufkin, founded a boutique investment bank in the late 1950s catering to a new type of institutional investor.
Part of their strategy in dealing with this change was fairly simple: Commissions were fixed, so it made sense to target institutions that could buy a million shares rather than going after individuals interested in buying just a handful. What they also noticed was that investors were testing the stock market waters by purchasing the companies they knew and were still allocating 70 percent of their portfolios to bonds.
Their firm, Donaldson, Lufkin & Jenrette, began putting out research reports touting the advantages of branching out from the old blue chips and into promising growth stocks. “Our reports were fairly long,” says Jenrette. “If you were going to buy stock in one of these small companies, you needed to know a lot more about it than, say, GM, where you could get in and out quickly.”
What originated as a shrewd sales tool — the comprehensive equity research report — virtually transformed a bunch of back-office number-crunchers into what would within a decade become one of the most powerful and influential groups on Wall Street: equity analysts. Institutional Investor would begin ranking the top analysts in 1972 with its now-famous All-America Research Team, but Jenrette maintains that DLJ created this rarified league of Wall Street stars a decade earlier. “The analyst used to be a sort of green-eyeshade statistician,” he says. “We invented the analyst-salesman, where the analyst was turned loose.”
The logic of the DLJ approach became clear to many other firms, as did the outsize profits the young firm was raking in. Researchers not only helped build share within the market; they seemed to increase the size of it. Analysts’ reports and recommendations worked like advertising, piquing the interest of investors when there was no other news to be talked up. In this way, analysts begat more analysts. “The firms had to use them because there was more competition for customers,” says Charles Geisst, author of Wall Street, A History.
This rapid-fire transformation of the research industry was a long time in coming. Financial historians describe the decades between the ’29 crash and the mid-1950s as giving rise to Wall Street’s “lost generation.” A young man who would have chosen a career in investment banking instead went elsewhere. It was only in the late ’50s, when Donaldson, Lufkin and Jenrette were graduating from business school, that the promise of a postwar bull market lured the best and brightest back to Wall Street. By that time, old-line underwriters, who landed deals largely as a result of personal relationships forged in the exclusive clubs of Boston, New York and Philadelphia, were being challenged by a new crop of ambitious firms eager to win their own lucrative underwriting gigs.
Wall Street’s new meritocracy — DLJ among them — reasoned that the best way to distinguish their talents was through their equity research departments. The merger boom that began in the late ’50s continued over much of the next decade as conglomerates became a popular way for companies to insulate themselves from various levels of risk. According to Geisst, even General Motors, a longtime Morgan Stanley client, began to use other investment banks to underwrite its new issues. The preponderance of large corporations shopping around for investment banking services placed even more importance on the role of the equity analyst. Banks could use their research departments as a way to curry favor with potential clients, with the veiled promise that the banks’ analysts would provide upbeat reports on the clients when it came time to attract new infusions of institutional money.
Analysts understood their sectors and had all the industry contacts. But beyond that, their participation as part of a bank’s underwriting team impressed potential clients and carried an implicit promise of favorable coverage in the future. At first, the big investment banks didn’t follow DLJ’s enthusiastic lead; they viewed research as something of a necessary evil. In his 2008 book, The Partnership: The Making of Goldman Sachs, author (and Greenwich Associates founder) Charles Ellis says that longtime Goldman, Sachs & Co. chairman John Whitehead had mixed feelings about spending $6 million a year on the function in the 1970s. But by the 1980s the bulge bracket dominated II’s rankings and the banks’ research budgets could run into the hundreds of millions of dollars a year, subsidized in large part by the underwriting side.
Moreover, if the banks wanted to be in the business of making lucrative block trades, they had to match the boutiques’ and brokerages’ research teams, because for institutional investors analysts represented not just an important tool in the drive for higher returns but something of an insurance policy. Legal precedent such as the prudent-man rule (which stemmed from an 1830 Massachusetts court decision) as well as subsequent legislation absolved fiduciaries of blame for individual bad investments provided the portfolio as a whole was responsibly invested. For a pension fund overseen by a board with little experience or specialized knowledge that was suddenly convinced that equities had to be part of the plan, the imprimatur of an expert researcher, supported by reams of paper, held considerable importance. “They would take the sell-side research somewhat seriously and keep it on hand,” Geisst says of fund managers.
In the early 1960s automobile manufacturer Studebaker Corp. went belly-up, overwhelmed by pension obligations and declining market share. When the automaker defaulted on its pension obligations, the United Auto Workers union was left holding the bag. The UAW wanted the federal government to take responsibility for the pensions; the default triggered years of political wrangling that resulted in ERISA, which created, among other things, the Pension Benefit Guaranty Corp.
Uncle Sam agreed to insure private pensions; in return, he set strict standards for institutional money managers. ERISA also included mechanisms for IRAs and 401(k) and 403(b) defined contribution plans. In the 1950s and ’60s, pension funds and other institutional money managers did not see themselves as investment advisers. Many of them were employees of their company or members of its board of directors — people with no financial experience who did not want to be held personally liable for bad investment decisions.
Their fear proved well founded. A study by A.G. Becker & Co. in 1968 showed that most institutional money managers didn’t know their assets from their elbows. They consistently underperformed the broad market, thus running afoul of the prudent-man rule. DLJ exploited this opportunity by marketing its research to fund managers — for a fee, of course. (Ironically, DLJ never won the All-America Research Team.) The pension fund manager didn’t have to personally vet each investment; he or she could rely on a Wall Street researcher.
For all that, technology placed enormous limitations on the quality and quantity of information that an analyst could produce. Texas Instruments introduced the first handheld calculator in 1969, and analysts were among the earliest adopters, but John Mackin, a 24-time All-America Research Team member who in 1967 began a 32-year Wall Street career covering Machinery at Burnham & Co., remembers several years of working with a slide rule. Charting even the most basic metrics — growth or earnings history, for example — involved visiting a library to examine Moody’s annuals, which provided data for all public companies, then having an assistant copy out relevant passages line by line because photocopiers were not yet widespread. “Gathering the kind of information you can get in five minutes today might have taken a month,” says Mackin.
Given the commissions they were paying, institutional investors looked upon free sell-side research as their due. Indeed, as the stock market continued its tear through the 1960s, more and more institutional investors wanted in. Separate studies in 1965 and 1968 showed that both mutual funds and institutional funds were unable to beat the overall market; one inference was that they needed more stock-picking help.
Although not a precise analogue, the number of Chartered Financial Analysts increased to 3,219 in 1972 from 268 in 1960 and would roughly double every decade hence. And the pay was more than respectable. In 1971, when the average house was worth $25,000 and a new car cost $2,000, a junior Wall Street analyst started at $15,000 and rose to $25,000 to $50,000 at midcareer, with six-figure salaries for a few.
On May 1, 1975, the Securities and Exchange Commission mandated an end to fixed commissions, instantly opening up the business to discount brokerages such as Charles Schwab and dramatically forcing down transaction costs throughout the industry; this provoked widespread consolidation and the closing of numerous brokerages. “The analysts were still in demand, but the revenue to pay them wasn’t there,” says Jenrette. “The old institutional brokerage that was a gold mine in the ’60s became a land mine in the ’70s.”
Subsequent SEC legislation specified research as a “safe harbor,” ensuring that its cost could legally be included in the price negotiated for trades (unlike dodgier “soft dollar” extras such as IPO allocations and marketing favoritism). Jenrette speculates that when the SEC mandated negotiated commissions, its hand may have been forced by the prospectus DLJ issued in 1969 on its way to becoming the first significant Wall Street firm to go public. The revelation that DLJ had been running profit margins in the 50 percent range dramatized how lucrative fixed commissions of 35 cents a share could be and stirred up considerable agitation on the buy side. Somewhat ironically, the combination of the 1970s bear market and the May Day reforms meant the firm was never able to deliver comparable returns as a public company.
Even if the investment banks continued to pile into research, it was not a growth period for the practice or for capital markets in general. In 1978, when Lehman Brothers and Kuhn, Loeb & Co. merged, their total capital was a mere $78 million. In an environment dominated by pessimism and confusion, bond analysts like Salomon Brothers’ Henry Kaufman gained prominence over their equity counterparts, and as stagflation intensified late in the decade, markets of all types reached a low ebb. The U.S. economy did likewise, sinking once again into recession in the second half of 1980.
The mutual fund industry, which has consistently managed almost half of all IRA assets, contributed to the rise of in-house research analysts during the period. The research focus was purer, with little need for marketing and no need at all to support sales or investment banking functions. And there was another key reason that when an analyst from an investment bank did happen to cross over to a mutual fund, the position was far more likely to be portfolio manager than researcher. As Jenrette says, “The pay was better.”
A direct hit to analysts came from the junk bond scandal that felled Michael Milken and Drexel Burnham Lambert, which in 1989, while already embattled, placed 38 members on the All-America Research Team, the fourth-highest number, after leading all others in 1988. For analysts the end of the 1980s marked a period of considerable movement, as departing Drexelites and others sought safe haven, and not always as researchers. Ever since the 1960s the field had been viewed as a direct path to portfolio management, and in its 1990 edition II reported that at least a half dozen members of the 1989 team had left to manage money.
But another bull market was beginning for equities, and capital markets became sexy and interesting again. In 1995, CNBC began reporting directly from the New York Stock Exchange floor. In August of that year, II All-American Mary Meeker served as analyst as Morgan Stanley led the IPO for Netscape Communications Corp.; a few months later, with Chris DuPuy, she wrote The Internet Report, which became a bestselling book. Early that year the tech-heavy Nasdaq Composite Index began a phenomenal rise that would take it from 800 to more than 5,000 in just five years. The Internet bubble marked the pinnacle of research analysis, the true rock-star years. Celebrity analysts retained their own press agents, and brokerages installed television studios in their offices.
Dan Reingold was a well-known telecommunications analyst who chronicled how equity researchers became household names during the Internet bubble in his tell-all book, Confessions of a Wall Street Analyst. He recalls attending a dinner in the late ’90s at which he asked Henry Blodget, Merrill Lynch & Co.’s star Internet analyst, to introduce AOL chief executive Steve Case to the crowd. Blodget jumped at the chance, telling Reingold that he would be introducing someone he’d never met. “Hmmm, I thought to myself,” said Reingold. “This guy covers AOL and, on behalf of Merrill Lynch, recommends its stock to thousands of individuals and institutions around the world. How can he publish research reports on a company without having met the driving force behind it? Geez, I bet sixth graders feel they know Steve Case better than Henry Blodget does.”
Then there was Reingold’s first run-in with Jack Grubman, the Salomon Brothers analyst who would become his archrival, when he was still working in investor relations for MCI and Grubman had just written a negative report on the telecom giant. Reingold contacted Grubman to counter his damning report point by point. Yet Grubman didn’t even attempt to debate Reingold and casually told him he’d verified the information he used by running it past a buddy at AT&T. “Now I’m a pretty calm guy, but I almost lost it when I heard that,” Reingold wrote in his 2006 book. “[Grubman] had relied on someone who worked for AT&T, a competitor that would do almost anything to discredit our long distance service. Was this how Wall Street research was done, by relying on biased sources and unchecked assumptions? What offended me the most was the notion that Jack Grubman was more interested in making a splash than in really understanding what he was writing about.”
The splashy rock-star years didn’t last long. The first blow to the research industry was the SEC’s Regulation Fair Disclosure, enacted on August 15, 2001, prohibiting disclosure of material information to select people — including securities analysts. “Prior to Reg FD companies would be much looser about their thoughts about what might happen,” says longtime DLJ analyst Dennis Leibowitz, who during his nearly 40-year career on Wall Street was ranked No. 1 in Broadcasting, Cellular, Communications or Lodging 25 times. “Even if they didn’t give forecasts, they would be much more open about where they saw things going, and they would be willing to say more without worrying that they had to put out a press release or tell the world. Companies didn’t think so much that what they were saying was subject to oversight by regulatory authorities, because it wasn’t.”
Surveys of institutional investors, including II’s own poll during the compilation of its annual research rankings, indicated minimal dissatisfaction on the part of investors. Many analysts, on the other hand, felt otherwise, especially because compensation was also taking a hit during the period. Christopher Dixon, who left UBS in 2003 to manage private equity investments at Gabelli Group Capital Partners, was among the exodus of senior analysts. Both analysts and markets suffered when it became more difficult to ask sophisticated questions in a timely manner, he says. “How are you optimizing capital structure, and what are you doing with cost of capital, and are you issuing debt or buying back stock? These are questions that you probably couldn’t ask except as part of a conference call,” Dixon says.
For analysts at investment banks, there was worse to come in the form of the global settlement reached in April 2003 under which ten firms paid $1.4 billion in fines and agreed to a series of reforms meant to eliminate conflicts of interest between investment banking and research departments. In preventing analysts from communicating with underwriting teams or sharing in banking revenues, the settlement left the funding of research departments wholly dependent on trading commissions — at a time when commissions were rapidly shrinking because of cheaper electronic trading.
The financial crisis that peaked in 2008 began because of a liquidity shortfall primarily caused by overinvestment in the U.S. real estate market. Matters accelerated as a trickling stream of bank failures that began with subprime lender Countrywide Financial Corp. swelled into a raging flood that carried away some of the biggest names on Wall Street, including Bear Stearns Cos. (taken over by JPMorgan Chase & Co.) and Lehman Brothers Holdings (part of which was snatched up by Barclays). As a result, according to a managing director at a Wall Street brokerage who wishes to remain anonymous, the link between investment banking revenue and research has been weakened. But he says there are still companies out there that view research as very important when considering which bank they will use for underwriting, and his firm, which has almost no research component, is losing business to brokerages that offer more.
And fundamentals still count for something too. High frequency traders deal in hundreds of shares in hundredths of a second, which isn’t going to move prices, the Wall Street executive says. By contrast, if a mutual fund, pension fund or hedge fund buys something, they’re making a judgment about valuation, and it’s going to affect valuation, he says: “The fundamental analyst will always win out in the end.”
Richard Jenrette says the same kind of fundamentals used by the back-office statisticians of the late 1950s are making a renaissance on Wall Street. “Lo and behold, we’re back to statistics,” he says. Of course, disciplines that revert to the ways of a half-century ago often discover that the road to success is harder the second time around. • •
