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Maybe you can have too much of a good thing. In 2003, as part of the $1.4 billion global settlement designed to address Wall Street’s conflict-of-interest ills, the Securities and Exchange Commission ordered big investment banks to allocate hundreds of millions of dollars to independent research. As a result, demand for independent research has never been greater — but even so, it is being outstripped by supply. In the past three years, the number of firms offering independent research has mushroomed, from an estimated 150 in 2003 to more than 600 today. Competition has turned so fierce that some of the best-known and most highly regarded firms have been driven from the business, even as others are struggling to distinguish themselves in a suddenly crowded marketplace.
Case in point: the Precursor Group. In December 2005 the Washington-based research organization was named the top firm in three of the independents’ telecommunications sectors in Institutional Investor’s annual rankings of the Best Boutiques, Regionals and Independents research firms. That month the firm closed its doors to seekers of investment advice, dropped the word “group” from its name and dedicated itself to industry and policy research for companies. “We saw virtually every trend in the investment research business getting worse — supply exploding, pricing collapsing and regulatory burdens exploding,” says CEO Scott Cleland. “That’s a lousy business environment.”
Another former winner in the II rankings, Foresight Research Solutions of New York, shut its doors earlier this year, and Sturza Institutional Research, which focused exclusively on health care, closed in July. Late last year, Fulcrum Global Partners sold its research assets to Soleil Securities, ending the reign of yet another independent research firm and former winner in II’s annual rankings; the New York–based firm took eight first-place spots last year.
Michael Mayhew, CEO of Integrity Research Associates in Darien, Connecticut, believes more changes are on the way. “I expect to see a shakeout, more from the independent community than the brokerage community, because brokers have better sales and distribution capabilities,” he says. “A lot of small and midtier investment banks and broker-dealers will go out of business, or get out of the execution business, or decide to be execution-only shops.”
Eric Bosshard and Chris Byke are two who decided it was time to get out of the execution business. In June they left Cleveland-based FTN Midwest Securities Corp. to create a shop dedicated exclusively to research. Their firm, Cleveland Research Co., has 13 senior analysts following 175 stocks in the consumer, health care, industrial and technology sectors, as well as 23 associate analysts and market research associates who gather data for analysis. Cleveland Research does not distribute its findings publicly, and the firm limits its client base to 125. “If you go beyond 125, you start to destroy the value to those customers,” explains research director and CEO Bosshard. “Both our customers and ourselves get a diminishing return if we have more customers.”
With established names closing up shop and new firms opening their doors seemingly every day, how can investors determine which independent research providers offer analysis worth buying? To answer that question, II polled portfolio managers and analysts at hundreds of asset management firms and hedge funds. Some 730 voters submitted ballots for boutique and regional firms; over 350 cast ballots for independent firms. For boutiques and regionals, we received sufficient balloting to publish results in 34 of the 71 categories in the 2006 All-America Research Team; for independents there was enough depth of voting to publish results in 41 categories. Voters were free to categorize research firms as they chose; therefore, some firms received votes in both the boutique-regional and independent categories.
Most highly rated among independent research providers is Sanford C. Bernstein & Co., which finishes first in 23 categories, four more than last year. Famous for its black books — massive and comprehensive tomes on companies and industries — the New York–based firm has been expanding to meet the increased demand for independent research. Bernstein has doubled the size of its U.S. core research department, boosting its coverage universe and building up a parallel business in London covering pan-European stocks. Today, Bernstein has a team of 50 analysts: 33 in the U.S. and 17 in Europe. “We went from covering 45 percent of the companies in the Standard & Poor’s 500 index to covering between 75 and 78 percent,” says Lisa Shalett, chairman and CEO, adding that the firm is looking to further increase coverage in certain sectors, particularly in the small- and midcap areas.
“What I like about Bernstein is that their analysts are capable of doing more thorough research and are required to do more thorough research in their deep dives,” says one New York–based buy-sider. “And you know with Bernstein they’ve made sure that what goes out the door has value.”
Sticking with the formula that has worked for years gives Bernstein both brand equity and competitive advantage, Shalett asserts. She acknowledges the growing appetite for quick trading ideas and the trend among sell-side firms to provide concierge service — for instance, picking up company managements and driving them around a city to meet with investors — but she says the firm is not buying into either. “We pride ourselves on having stuck to our knitting,” she says. That’s not to say Bernstein is resting on its laurels; the firm has added to its macro research with global strategy and technology offerings.
Many of the new independent research firms have been established by veteran analysts leaving investment banks to strike out on their own. In January retailing analyst (and seven-time All-America first-teamer) Dana Telsey left Bear, Stearns & Co. to launch Telsey Advisory Group. The firm has 17 junior and senior researchers covering 38 stocks in four retailing sectors — broadlines, hardlines, luxury goods and specialty stores — and Telsey says she plans to expand into other consumer sectors. TAG is a registered investment adviser, not a broker-dealer; as such, the firm performs neither investment banking nor trading.
Telsey acknowledges there have been a lot of new entrants into the independent research industry, growth she attributes to “increasing market demand for research without the layers of bureaucracy you’ll find at large brokers.” To distinguish her firm from other independent research providers, Telsey publishes 12-month target prices rather than issuing buy, hold or sell ratings, and she says this approach gives clients a more useful and flexible tool, as ratings don’t always fit their time horizons or investment philosophies. TAG’s research is distributed by e-mail and online at the firm’s Web site, rather than disseminated to FirstCall or other public sources, so clients have exclusive access to TAG analysts.
Another new entry is Pali Capital, whose U.S. research division was formed when analysts Richard Greenfield and Walter Piecyk left Fulcrum in November 2005, bringing a veteran research team of three senior and three junior analysts to the decade-old New York execution shop. Greenfield and Piecyk, co-heads of research, expect to double or triple the size of the department by the end of 2007. “The benefit of independent research is that we can write about any topic we want at any time,” Greenfield says.
To stand out from the growing crowd of independent research providers, Pali focuses on underfollowed companies and previews of initial public offerings. For instance, before Vonage Holdings Corp.’s IPO in May, Greenfield told clients he would not pay more than $10 a share for the Holmdel, New Jersey–based broadband telephone service provider’s stock, reasoning that increasing competition would make it difficult for Vonage to maintain its low-pricing strategy. The Vonage IPO was priced at $17 a share, and Pali initiated coverage with a sell rating; by mid-November the price had fallen 60.4 percent, to $6.73.
Newcomer Cleveland Research boasts first-team winners in Retailing/Broadlines & Department Stores, Retailing/Food & Drug Chains and Health Care Facilities and a second-team slot in Retailing/Hardlines. “The biggest difference between us and the typical sell-side firm is that we’re not as focused on a relationship with management,” Bosshard says. “Instead, our most important contacts are in the channel.” Those channel contacts paid off in October, when machinery analyst Mark Koznarek published a report, “Inflection Point Reached for U.S. Construction Equipment,” stating that because demand in the U.S. construction market had slowed materially, Caterpillar was not likely to meet its third-quarter earnings forecast. At the time, shares of the Peoria, Illinois–based construction-equipment manufacturer were trading at $68.78. Clients who sold their shares on October 18, the day Koznarek issued his findings, have reason to be grateful; two days later, Caterpillar reported earnings below expectations, and the share price fell 14.2 percent, to $59.00.
Among boutiques and regional firms, Boston–based health care shop Leerink Swann & Co. earns five first-team finishes this year, one more than last year: Biotechnology, Health Care Technology & Distribution, Medical Supplies & Devices, Pharmaceuticals/Major and Pharmaceuticals/Specialty. Two New York–based boutiques, Buckingham Research Group and Keefe, Bruyette & Woods, each earn four first-team spots. Buckingham is the best of the boutiques and regionals in Paper & Forest Products; Apparel, Footwear & Textiles; Restaurants; and Retailing/Broadlines & Department Stores. Financial services boutique KBW takes top honors in Banks/Large-Cap, Banks/Midcap, Brokers & Asset Managers, and Specialty Finance.
Sector-specialist firms place extreme focus on one particular market area and provide deeper and more thorough coverage, say buy-side fans. Leerink Swann’s research department covers 140 health care stocks with a team of 25 (12 senior analysts and 13 associates) and expects to add three or four analysts next year to increase the number of stocks followed. Its MEDACorp. affiliate, a network of 22,000 doctors and medical researchers, gives Leerink’s analysts a leg up on the competition, says research director Chris Kotowski: “Our analysts can tap more resources than our competitors.” When Leerink analysts have a question about a particular product or therapy in development, they can get frontline feedback on its viability and market demand from a MEDACorp. network doctor. Leerink’s clients also have access to MEDACorp. doctors and researchers, should they have questions or seek insight independent of Leerink analysts.
In August 2005 a MEDACorp. survey identified biotech companies working on potentially promising new RNA interference-based treatments and concluded that Sirna Therapeutics of San Francisco was especially well positioned, given that its products were further along in clinical development and its multiple partnerships would enhance its distribution capabilities. In April, Leerink initiated coverage of Sirna with a buy, at $7.89. Six months later, Merck & Co. announced it would buy Sirna for $13 per share, or $1.1 billion.
Fox-Pitt, Kelton, a financial services specialty firm that until late June was a subsidiary of Swiss Re, wins top honors in Insurance/Life and Mortgage Finance. The firm follows 185 stocks with 18 publishing analysts in the U.S. and research departments based in London, Hong Kong and Tokyo. “Years ago the product was information,” says Alan Zimmerman, research director, but with Regulation Fair Disclosure and electronic media, “information is democratic, and the value of information is zero. Now the value is insight and perspective.”
Research providers are finding ways to distinguish themselves by creating new types of niche firms. Data compilers, channel checkers and expert networks have exploded onto the scene, as have research shops that use technology to sweep and scrape the Internet for information and data to analyze. New York–based Majestic Research uses a proprietary Web harvesting technology to gather data for analysis, but the firm offers no buy or sell recommendations. Majestic collects information online, then employs quantitative analysts who incorporate the data into models and predictive metrics to gauge possible impact on stock prices. For example, the firm might gather data on revenue from gaming companies based on slot machine and table usage and identify trends for future growth prospects. Foster City, California–based FirstRain offers Web-based information gathering on companies and their ecosystems: customers, competitors and supply chain.
Competition among independent research firms — both the new and the well established — is expected to intensify even as the demand for independent research increases. Spending is expected to top $800 million in 2006, up from $750 million last year, according to a recent study by Greenwich Associates, a Connecticut-based financial services research firm. As a percentage of total research budgets, spending on bulge-bracket research fell 4.3 percent from 2004 through 2006, even as spending on regional or sector specialists rose 3.2 percent and on independent providers, 1.2 percent, according to Greenwich.
Integrity Research’s Mayhew predicts that spending on independent research will increase 30 percent next year as the continuing trend toward unbundling — separating the economics of research from trading — and the commission-sharing agreements that allow buy-siders to pay one firm for trading and another for research will help fuel the demand for independent research. Nonetheless, even with more and more money being allocated to independents, it remains to be seen if the market can support so many research providers — or which of this year’s winners will be around for next year’s rankings.
