Finding winning stock picks is a challenge even when the economy is expanding and the stock market is rising; identifying safe havens can be equally tricky when conditions take a turn for the worse. Sell-side equity analysts who track U.S. companies were called upon to do both over the past year, as the Standard & Poor’s 500 index shot up 18.7 percent from its low point in the fourth quarter of 2009 to late April, plunged 16 percent through early July and then rebounded 10.3 percent by early August — only to fall 7 percent through the end of that month.
The shaky U.S. economy was repeatedly rattled by overarching events both foreign and domestic: drawn-out, partisan debates on health care and financial reform in Congress; sovereign debt crises, first in Dubai and then in Europe; a disastrous oil-rig explosion in the Gulf of Mexico; and more. Analysts had to keep on top of developments in all of these issues as they sought to guide anxious clients through tumultuous times.
“The market was driven by macro events, and analysts needed to understand and interpret those events to provide perspective on which sectors and stocks would outperform,” explains Thomas Schmidt, J.P. Morgan’s New York–based head of Americas equity research.
As Stephen Haggerty, who directs coverage of North and South American equities for BofA Merrill Lynch Global Research in New York, observes: “It’s been a tough year to be a sell-side analyst.”
True enough, but the past year’s market and macroeconomic extremes offered analysts an opportunity to prove they were up to the challenge, and the ones who impressed investors the most can be found at J.P. Morgan, which rises from second place to take top honors for the first time in the All-America Research Team, Institutional Investor’s annual ranking of the nation’s best sell-side equity analysts. J.P. Morgan captures 46 total team positions, two more than last year.
Down a notch to second place is the research squad that has dominated this ranking for the past seven years, five as part of Lehman Brothers and the past two at Barclays Capital. (The researchers moved en masse after Barclays acquired the North American operations of Lehman Brothers Holdings in September 2008.) The BarCap crew takes 43 positions this year, down from 46.
BofA holds steady in third despite having picked up five more positions, bringing its total to 42. Rounding out the top five are Credit Suisse, which rises one rung after adding three more positions, for a total of 34; and UBS, which slips one notch after losing four positions, leaving it with 29.
Morgan Stanley is the biggest upward mover among the top firms, rising from ninth place to seventh after boosting its team-position count by eight, to 24. Even more striking: The number of Morgan Stanley analysts ranked No. 1 in their respective sectors catapults from one last year to eight this year. Only three firms claim more top positions than Morgan Stanley: J.P. Morgan, BarCap and Sanford C. Bernstein & Co.
Profiles of the analysts and teams in first place can be found in Research & Rankings, beginning on page 71; complete results, including profiles of analysts and teams ranked second and third and the list of runners-up can be found on our web site, institutionalinvestor.com. Survey results are based on responses from nearly 3,500 portfolio managers and other investment professionals at some 970 firms that collectively manage an estimated $10.2 trillion in U.S. equities.
“The events of this year reiterate that analysts need to be more focused on what is going on around the globe and how it can affect their coverage universe,” says Schmidt. “But the core, fundamental work that analysts do on specific companies has not changed.”
One thing that has changed: “Clients have increased the demand they are putting on sell-side research departments to explore new opportunities,” he says. To keep up with this demand, J.P. Morgan has added three analysts over the past year, bringing its total to 58 senior researchers who follow a whopping 1,135 U.S. companies — 50 more than last year and the highest number of any firm — and Schmidt says they will initiate coverage on an additional 20 to 30 stocks over the next 12 months.
BarCap has 65 senior analysts this year — that’s one less than last year — but they added coverage of 15 stocks, for a total of 965. Stuart Linde, the firm’s New York–based head of global equities research, says the firm will be expanding its coverage more aggressively, with a goal of tracking 1,100 companies by 2012. He has no plans to increase his senior-analyst head count but may hire more junior analysts to help with the increased workload.
With macro concerns dominating investors’ minds, BarCap is deploying its resources more strategically, focusing on global and equity-linked products that span asset classes.
“Our clients want any kind of incremental insights that will help them generate greater returns for their portfolios,” Linde explains. “What we’ve tried to do is ensure we have an integrated approach within and outside equities. As a result, the look and feel of our reports is significantly improved.”
BofA expanded its research operations by roughly 9 percent, to a staff of about 80 senior analysts, Haggerty says, and their coverage universe grew by about 20 percent, to 950 companies. “We wanted to drive stock coverage and increase the firm’s equity analyst base, in line with client interest,” he says.
Morgan Stanley’s rise in the ranking can be attributed at least in part to the firm’s renewed commitment to the U.S. market. Stephen Penwell, New York–based director of North American equity research, has brought 14 analysts on board over the past year, for a total of 62, and plans to add seven to ten more by year-end 2011.
“We expect the department to grow modestly over the next year, as we fill a couple of important coverage holes and continue to develop our best internal talent,” he says. Morgan Stanley researchers follow 755 stocks — an increase of more than 120 companies over the past year — and will have initiated coverage of about 50 more by December. “We felt our footprint, in terms of analysts and stocks covered, was too small to be competitive as a top firm in the U.S. equity markets,” Penwell explains.
It’s an interesting time to double down on the U.S. market, as many investors still fear a double dip. The so-called Great Recession officially ended in June 2009, after 18 months — the longest downturn since World War II — the National Bureau of Economic Research reported last month. Even so, real gross domestic product growth is anemic and the unemployment rate remains above 9.5 percent, with some 15 million Americans out of work.
“The market has traded sideways in a relatively broad range, as market participants have vacillated between betting on growth and betting on a double-dip recession,” Penwell observes. “Equity volumes have been subdued as a result of the lack of clear direction.”
Of course, it’s clear direction that investors need most when uncertainty abounds, and few segments of the American economy have been as shrouded in uncertainty in recent years as the financial services sector. As long ago as March 2008, when the Federal Reserve Bank of New York helped arrange the shotgun marriage of JPMorgan Chase & Co. and Bears Stearns Cos. to prevent the latter from a bankruptcy that many believed would devastate the nation’s financial system, legislators began talking about reforming the way Wall Street conducts business.
The conversation continued through the bailouts of the Federal National Mortgage Association and the Federal Home Loan Mortgage Corp., the collapse of Lehman Brothers and the rescue of insurance behemoth American International Group. They were still discussing the subject when Merrill Lynch & Co. was sold to Bank of America Corp., Morgan Stanley and Goldman Sachs Group were converted to bank holding companies, and Congress passed the controversial, $700 billion Emergency Economic Stabilization Act of 2008. It was not until July 2010, when President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, that the contentiously debated regulatory reforms became law.
While legislators were wrangling over how extensive an overhaul of the nation’s financial system was required and the form it should take, investors were dependent on analysts to keep them apprised of every development, proposal and even rumor, for all had the power to move the markets. Money managers were especially impressed with Sanford C. Bernstein’s Kevin St. Pierre, who finishes in first place for the first time in Banks/Midcap.
“I find Kevin’s work valuable because of the detailed financial analysis he does of the industry and of the companies he follows,” says one client. “His work has been particularly useful in light of the raft of regulatory and legislative changes.”
Those changes had a “huge impact” on his sector, St. Pierre notes — but there was an even bigger issue: the turn in the credit cycle. “A year ago banks were furiously building their reserves and raising capital, but fast-forward to right now — banks are doing the opposite,” he explains. “They are releasing reserves, drawing down their reserve coverage, and some are even beginning to think about how to use their excess capital.”
Loan-delinquency rates, which had been surging throughout much of last year, began to slow in the fourth quarter, indicating that the peak would be significantly lower than many people had feared, he notes. St. Pierre had been urging clients to underweight their holdings in his sector, but last fall he changed course and advised them to overweight midcap banks — especially those whose valuations had fallen the farthest.
“There is a price for every asset, and we felt those stocks had drifted significantly below even a worst-case scenario, in terms of losses,” he says. In April, when the shares had corrected to what he saw as appropriate valuations, he declared it was time to take profits.
“We told investors they should migrate toward safer, more-profitable names that had already repaid their loans from the Troubled Asset Relief Program and were building capital, as opposed to eroding it,” he explains.
St. Pierre says it’s too soon to tell what the long-term effect of the Dodd-Frank reforms will be. “We’ve only just begun to see how it will impact the banks’ ability to generate revenue,” he notes. Nonetheless, he is confident they will adapt to defend their margins. For instance, the new law imposes restrictions on banks’ use of overdraft fees on debit cards, which had been a major source of income for many issuers, but some lenders will offset that lost revenue by charging higher account-maintenance fees.
“The banks are trying to backfill some of what is going to be eliminated, so I think that, yes, it’s going to be a hit to profitability, but not as large as some fear,” he says.
Disproportionate fear has also hammered the insurance industry, but not because of financial reform, according to the analysts whom investors say do the best job of providing coverage: J.P. Morgan’s Jamminder (Jimmy) Bhullar, who wins the top spot for the first time in Insurance/Life; and BarCap’s Jay Gelb, a first-time first-teamer in Insurance/Nonlife.
The AIG debacle — in which the troubled insurer was forced to seek an $85 billion lifeline from the federal government, owing to a lack of liquidity — rendered other outfits in the group guilty by association, at least in the minds of many investors. After all, if a company that was ranked among the world’s 25 largest by revenue in 2007 could suddenly find itself without enough cash on hand to meet its obligations, couldn’t the same fate befall a smaller institution?
“Sentiment on the group is extremely negative,” says Bhullar. “Our stocks are trading at 80 percent of book value and only seven times next year’s earnings.”
That negativity remains, he says, despite the improvements in life insurers’ fundamentals and balance sheets that are thanks in part to the loosening of credit.
A similar phenomenon is affecting nonlife companies. Many property and casualty insurers and reinsurers — Ace, Arch Capital Group and Travelers Cos. among them — have strong financial positions and excess capital, and given their relatively low valuations, one would expect investors to gobble up the shares, Gelb says. But macro concerns are creating headwinds for the industry. Weak auto and home sales have slowed new-policy growth, as has the low rate of business start-ups.
Some insurers have raised premiums to help make up for the decline in sales, and many have undertaken cost-cutting initiatives to streamline profitability and boost excess cash, which they are using to buy back shares and buoy investor confidence. “But earning power is going to be somewhat compressed by such a low interest rate environment, and until you get a sustained economic recovery, top-line growth should be somewhat weak,” Gelb says.
Just last month the Federal Reserve Board opted to keep its benchmark overnight lending rate at a historically low 0.25 percent, and that does not bode well for insurers in the near term, Bhullar notes.
“The recent sector pullback has been due to fears of a double-dip recession and concerns about the possibility of sustained low interest rates,” which could prompt some outfits to lower their earnings estimates, he says.
Should that happen, clients know that Bhullar will keep them informed. “Jimmy is very conscientious about calling me
both before and after earnings releases to give me updates on his stocks,” says one pension fund manager. “I find his approach very helpful.”
Gelb’s backers are similarly supportive. “Jay is all about the hustle,” says one. “He is on top of everything and was the first to quantify the BP oil-rig loss on insurers, at a time when there was very little information.”
The explosion of the London-based global oil-and-gas company’s Deepwater Horizon drilling rig in the Gulf of Mexico, in April, claimed 11 lives and resulted in one of the worst environmental catastrophes of all time. It also sent shock waves through a sector about which investors had already been uneasy owing to wildly erratic oil prices over the past couple of years.
Gelb’s BarCap colleague Paul Cheng, who is No. 1 in Integrated Oil for the first time, had been negative on the sector since the start of the year, primarily because of low oil prices. “Over the last ten months, energy has been one of the worst-performing sectors,” he notes, adding that he expects oil to remain trading at $70 to $80 a barrel for the rest of the year and into the first quarter of 2011.
“There is still too much uncertainty on the economic front — we don’t expect oil to break out of this narrow trading range just yet,” states Cheng.
That said, low valuations make this the ideal time for investors to stock up. “We have probably seen the worst, and market expectation is low enough that we suggest clients gradually raise the portfolio weighting in the integrated-oil shares over the coming months,” he says.
He believes growth will resume by the second quarter of next year, but much will depend on what happens in Washington with regard to the Obama administration’s attempts to ban deepwater offshore drilling. In May the president called for a six-month moratorium in response to the BP disaster, but that ban was overturned by a federal judge in June. The following month, after the administration had lost on appeal, the Department of the Interior responded with a second moratorium, which is scheduled to end next month. But many analysts and market observers fear it may be extended.
“The outcome will impact the thinking we have about companies with a large exposure in the Gulf of Mexico,” Cheng says.
That view is shared by Morgan Stanley’s Ole Slorer, who makes his first appearance in the top spot in Oil Services & Equipment. “A situation where the lifting of the moratorium takes a full election cycle would be the worst-case scenario, and it definitely introduces some uncertainty,” he says. “The permitting of new exploration wells in the deepwater Gulf of Mexico will be a slow process, in any case.”
Companies in his coverage universe that did not perform well were those with connections to offshore drilling and construction, prompting investors to look elsewhere. Slorer knew just where to point them, because “he is always in tune with global issues and how they affect the sector, and he knows a good opportunity when he sees one,” says one longtime client.
“The biggest development in the sector this year has been the emergence of unconventional natural-gas drilling activity in North America and how it has transformed the pressure-pumping and stimulation markets,” he explains. “Pressure-pumping companies have therefore seen a big pricing cycle at a time when consensus had left this subsegment for dead.”
The analyst believes that the cycle peaked in August and that the next six months will likely be challenging. “It will be difficult to make money in the absence of a clear direction of global GDP growth, which drives energy demand and the need to drill more and produce more energy,” Slorer says.
However, a ban on offshore drilling could provide a boost to master limited partnerships, observes Gabriel Moreen, who lands in that sector’s winner’s circle for the first time. “The moratorium may mean additional capital spent onshore, in which case MLPs could benefit from the need for additional onshore energy infrastructure,” the BofA researcher says.
At a time when many analysts are cautious, Moreen is positively ebullient about his sector’s potential. “MLPs had a terrific run in the first half of 2010, delivering an almost 20 percent total return,” he says. Portfolio managers that flocked to partnerships in search of yield were rewarded with high dividends. “It is one of a few equity sectors that deliver the holy grail of high up-front tax-advantaged yields with growth at rates greater than inflation,” he says.
Moreen remains bullish. “Our mantra is, ‘If the corporate bond market continues to stay strong, it bodes well for MLP performance,’” he notes.
Investors are likely to take heed. “Gabe stands out, given his broad coverage of not only MLPs but also the closed-end funds that are the dominant owners of this sector,” explains one fund manager. “Perhaps the boldest call made by any MLP analyst over the past year was his series of upgrades this past May, amid a broader market correction and especially within this space, when he upgraded a number of MLPs — and he was right.”
Bold calls also helped propel J.P. Morgan’s Lisa Gill to the top spot for the first time in Health Care Technology & Distribution. “I like her independence,” declares one supporter. “She is willing to challenge the big names and so provides us with a sort of second opinion on our trades.”
Drawn-out partisan debate over health care reform caused every bit as much anxiety as the prospect of a financial system overhaul, but Gill alerted clients to an upside. She reassured investors as the debate was ongoing that her sector was relatively immune from its effects, in that most of the companies in her coverage universe do not participate in government programs such as Medicare and Medicaid, the expansion of which was one of the most contentious issues among sparring legislators.
After the Patient Protection and Affordable Care Act was enacted in March, Gill informed investors that the sector could see a modest boost. “Obamacare provides for incremental increased coverage for individuals, which could increase the amount and frequency of doctor visits and the use of drugs such as statins through pharmacy benefit management,” she explains.
While keeping one eye on developments in Washington, the analyst also kept investors apprised of another issue with far-reaching consequences: the expiration of patents on many drugs and a shortage of new, protected formulations. “There have not been as many new drugs developed by pharmaceuticals as in the early 1980s and ’90s, and fewer new patents have been issued,” she points out.
The so-called generic-drug wave began in 2006, when patent protection on Merck & Co.’s cholesterol-lowering drug Zocor and Pfizer’s antidepressant Zoloft expired, and will continue through 2015, by which time an estimated 80 percent of the market once held by brand-name pharmaceuticals will be taken over by generics, Gill explains.
So, even though health care reform will result in a greater number of Americans having health insurance and thus more people will probably be taking prescription medication, many of those drugs will be generics for which insurance companies pay less, and pharmacy profit margins will be squeezed. As a result, investors have become increasingly pessimistic about the sector’s future and are questioning its potential for growth, she says.
“We’ve gotten to the point where people are saying, ‘I don’t want to be caught not knowing what will happen in the future,’” Gill says. She remains bullish, however, and predicts that the specialty-pharmaceuticals industry, which includes biologics and self-injectables, will see annual sales expand from $60 billion to $70 billion currently to $100 billion by 2015.
A lot can happen between now and then — indeed, well before then. Some Republicans, anticipating a return to congressional power in next month’s midterm elections, have raised the possibility of repealing at least some provisions of health care reform.
Those elections are already causing anxiety elsewhere in health care markets, according to Derik de Bruin, who debuts at No. 1 in Life Science & Diagnostic Tools, a sector added to the survey this year.
“There was already growing concern over possible reductions in government funding to academic labs, in the wake of European austerity measures,” the UBS analyst says. “Now there are worries that if the Republicans win big in the midterm elections, then discretionary spending for non-defense-related R&D programs could face budget cuts.”
De Bruin has been doing his best to allay investors’ fears, reminding them that “the National Institutes of Health, the biggest source of funding for U.S. academic labs doing biomedical research, has friends on both sides of the aisle.”
He notes that his sector served as a relatively safe haven in the volatile health care landscape — “there was lots of money hiding out in life sciences” — and even though it too experienced a sell-off recently, he continues to pound the table and sees opportunities for tremendous growth.
“Three years ago it cost well over $1 million to sequence a whole human genome, and now the price is down to about $10,000 and still falling, so there has been tremendous progress,” de Bruin says. Mounting legal challenges to the validity of gene patenting have stemmed some of the optimism, because “the technology is moving faster than the legal framework was prepared for,” he adds.
Investors are confident that de Bruin can keep pace with such a rapidly evolving sector. “He is very good at translating the science into actionable investment recommendations,” says one pension fund manager. “We know that he knows what these technologies are worth and, more importantly, which ones are actually new and exciting and which ones are just an old business dressed up with confusing new technology.”
Federal legislation — albeit of a much different sort than health care reform — had a positive impact on Electrical Equipment & Multi-Industry, according to that sector’s top-ranked researcher, Scott Davis. The Morgan Stanley analyst, in his first appearance at No. 1, notes that the American Recovery and Reinvestment Act of 2009, the $787 billion economic stimulus package that Congress approved in February of that year, provided a much-needed boost to many of the companies in his coverage universe.
“Even small improvements in revenue growth are leading to very nice earnings surprises,” says Davis. “After two tough years the fact that people can talk about order books getting better means there is light at the end of the tunnel.”
The best may be yet to come, he points out. “It typically takes at least a year to get projects approved and the engineering work done,” Davis explains. “It’s been a year and a half, and we are now seeing real money being pumped into infrastructure projects such as water, wastewater and railways.” He expects the trend to continue and is bullish on the sector. “Positive surprises could come from later-cycle markets such as construction and power generation, which have been severely depressed for several years now,” Davis adds.
Growing interest in environmentally friendly products has also been good for the sector, he says. Some of that can be attributed to stricter environmental regulations and HVAC — heating, ventilating and air conditioning — efficiency standards, which set off a need for equipment upgrades.
“Air-conditioning regulations have created a fair amount of business, and lots of energy-saving products are selling well now,” Davis says. Much of the environmental-upgrade cycle is being driven by companies’ desire to cut energy costs and operate in a more environmentally responsible fashion, but there is another benefit: “Payback periods for environmental investments have decreased considerably over the past several years, and now even simple upgrades like lighting, HVAC and motors can have a payback of less than two years,” he explains.
Not all companies in the sector have benefited equally, however. “When President Obama was elected, there was a lot of chatter that some sort of tax on carbon would be introduced in the form of cap and trade or even in a simpler form of increased subsidies for clean energy,” says Davis. That has not happened — at least, not yet — and thus the wind-power business has been extremely weak. “Visibility on a recovery here is low,” he notes.
Not so the recovery in ad markets. Just ask J.P. Morgan’s Alexia Quadrani, who rules the roost for the first time in Publishing & Advertising Agencies.
“I was most surprised this year by how quickly the advertising market grew, from turning in its worst performance in almost a century to becoming one of the most robust,” she says. “No one anticipated such a strong recovery.”
Newspapers took a beating last year, as the recession stoked concerns about the industry’s viability over the long term. But aggressive cost-cutting measures and a rebound in advertising helped bring many of them back from the brink, she adds, noting that newspaper stocks have more than doubled off their May lows and are up approximately 50 percent from one year ago.
“Many companies refinanced their debt, pushed out maturities and are now seeing better revenue,” Quadrani says.
Advertising agencies, by contrast, weathered the recession better than most other media companies because “they operate in many different businesses and geographies, which reduces their exposure to any one area that may be hit hard by the downturn,” she explains.
This is one segment of the economy in which next month’s elections are a cause for optimism, in light of January’s court ruling that set aside provisions of the Bipartisan Campaign Reform Act of 2002 limiting corporate spending in federal contests.
“The Supreme Court’s overturn of part of the McCain-Feingold Act should cause an increase in political advertising dollars spent during election season,” Quadrani notes, with newspapers and local TV stations the likeliest beneficiaries.
Clients who have known Quadrani for some time were not surprised that she was able to navigate the abrupt turnaround in her sector’s outlook. “She moved from Bear Stearns to J.P. Morgan a couple of years ago without missing a beat,” recalls one money manager. “And she has consistently added value in what has been a tumultuous couple of years.”
The recovery in advertising also provided a boost to companies in the Entertainment sector, in which BarCap’s Anthony DiClemente leads the ranking for the first time.
“Profitability across the board for most major ad buyers on a national level rebounded, and as a result, big U.S. multinationals have had the ammunition to spend more on advertising and marketing,” he explains. That sent the sector soaring — until April, when it started to fall to earth.
“It’s a temporary reversal based generally on macroeconomic concerns over housing, unemployment and consumer confidence,” DiClemente says: People began cutting back on their spending on fears of a double dip.
The downturn may only be temporary, but some changes may last far longer. For instance, cost-conscious Americans are not buying as many DVDs as they once did, and may never again.
“The presence of DVD rental companies has shifted consumer behavior away from DVD sales and more toward rentals, which are lower-priced transactions and therefore less profitable for the movie studios,” DiClemente says. Video piracy remains a major problem, cutting into studios’ profitability, but “if companies find a way to sell movies and TV shows globally in a secure way, they could make up in volume what they are giving up in price,” he adds.
Relying on higher-volume sales rather than higher prices may be a strategy that companies in all sectors adopt as the economy remains sluggish, because “balance sheets are flush with cash, and companies are cutting costs,” observes BofA’s Haggerty. “The outlook for U.S. companies is better than for the U.S. economy overall.”
Identifying which of those companies are likely to triumph is what the best analysts do, and the members of the 2010 All-America Research Team have proved that they are up to the challenge.
