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The most talked-about event in New York research circles this year occurred in London. Graham Copley, global head of equity research for HSBC, issued an incendiary memo to his staff, deriding them for producing “worthless” research that amounted to little more than analysis-free regurgitations of company presentations. “Many of our analysts,” he declared, “do not deserve to be paid this year.” The memo was leaked to the Financial Times in June and subsequently found its way into other newspapers, not to mention countless Weblogs and Internet chat rooms.
For analysts who have struggled in the aftermath of the 9/11 terrorist attacks and the subsequent turbulence in world markets, the Enron Corp. and WorldCom accounting scandals and the U.S. investigations into conflicts of interest, the memo was a tough pill to swallow at a very difficult time. With his blunt words, Copley fanned a raging debate about the state of sell-side research, the changing role of the analyst and the need for a new approach that puts a premium on innovative and useful investment ideas over so-called maintenance research.
“There is a lot of discussion here and elsewhere about the value of quarterly results and how much value is added by publishing four reports a year on the 3,000 companies we cover worldwide,” says William Kennedy, global director of research at Citigroup. “We have to ask ourselves, are quarterly results more beneficial to investors or speculators?”
What do investors want? In a word: everything. “They want deep industry trends, they want trading ideas they can use right now, and they want you to bring in company managements for them to meet,” says Robert Morris, who covers oil exploration and production companies for Banc of America Securities. Morris knows what he’s talking about: The thousands of money management professionals who responded to this magazine’s 2006 All-America Research Team® survey judge him tops in his sector for a fifth year in a row. “What you did in this job five years ago,” he explains, “won’t cut it anymore in today’s market.”
To succeed now, analysts must find new ways to add value, and brokerage houses must find new ways to approach research. Firms increasingly are urging analysts to communicate across coverage lines with one another so that their analyses include relevant information from related sectors or asset classes. Investors in supermarkets and drugstores, for instance, want analysts to be able to tell them how big retailers like Wal-Mart Stores might affect those sectors; likewise, more and more investors — particularly the burgeoning ranks of hedge funds — are embracing complex strategies that require knowledge of fixed-income and derivatives markets to supplement quality stock picking. More than anything, though, analysts need to take an old-fashioned, roll-up-your-sleeves approach to research, in which unique ideas are supported not just by number-crunching but also by intensive field work.
No Wall Street firm is doing all these things better than Lehman Brothers, which tops the All-America ranking for a fourth year in a row. The firm wins 50 total team positions this year, two fewer than last year, and claims 16 first-place finishes.
Lehman’s prominence and staying power is all the more remarkable in light of the tremendous turmoil that has engulfed sell-side research over the past five years. Industrywide scandals over conflicts of interest, sweeping new regulations and a series of market ructions have conspired to make research at once more difficult and less glamorous, leading some Wall Street firms to shift resources into areas they perceive as more lucrative, such as proprietary trading and private equity investing. The cumulative impact of these changes is strikingly evident in this year’s ranking, which features the biggest year-to-year shake-ups in recent memory.
Citigroup, which made a contrarian bet on boosting its research ranks while the rest of the industry pared back, vaults from fifth place to second, with a total of 34 team positions, six more than it garnered in 2005. Citigroup displaces Merrill Lynch, which falls to third, with 33 total team positions, down from 38 last year. Morgan Stanley, following a March announcement that it would cut its U.S. and European research teams by 7 percent — more than 50 analysts — takes a huge hit from survey voters, plunging from third to ninth in the ranking. Once a research powerhouse, Morgan Stanley’s tumble marks the first time it has failed to finish in the top five since 1994. Bear, Stearns & Co. and UBS return in fourth and fifth place, respectively (see table, page 40).
Unlike the maintenance researchers that Copley bemoaned in his memo, many of today’s best analysts rely for their ideas on sources outside the companies they cover. That’s a far cry from just a few years ago, when CFOs would routinely whisper their earnings forecasts to favored sell-siders and analysts, who often devoted as much energy to winning investment banking business as they did to picking stocks.
“Across the Street there is a new generation of analysts that is very talented in this new world,” says Kathryn Booth, global head of equity research at Bear Stearns.
Of course, some veteran analysts have long produced hard-hitting, fundamentals-driven reports. Citi’s Jonathan Litt, whose team finishes first in the REITs sector for a fourth consecutive year, has impressed investors with a series of “real estate–rich” reports that identified retailers whose property holdings are undervalued by the stock market. One report pointed out that auto-parts purveyor Pep Boys – Manny, Moe & Jack owned land and buildings worth $1.2 billion, even though the company’s market capitalization at the time was just $700 million. Of the 103 companies identified in Litt’s reports, 14 have been snapped up through merger or acquisition.
UBS is taking advantage of its international network to think globally and act locally, according to Mark Steinert, global head of equity research. Benjamin Reitzes, a five-consecutive-time first-teamer in Imaging Technology and a second-teamer in IT Hardware, and other UBS technology analysts traveled to Taiwan in September 2005 to view chip-making advances for Apple Computer’s iPod. Impressed, upon their return in early October, they issued a buy recommendation that preceded a 36.1 percent rise in Apple shares through mid-September.
Supplying investors with actionable ideas is more important than ever because the economics of the institutional equity brokerage business have changed drastically. New regulations prompted by the late-1990s’ scandals prohibit firms from funding research with investment banking fees, and advances in electronic trading have driven down per-share commission rates, slowly sapping the only remaining source of revenue.
“Technical change has broken the industry’s traditional business model,” Charles (Brad) Hintz, a Sanford C. Bernstein & Co. analyst who finishes third this year in the Brokers & Asset Managers category, told attendees at last month’s Securities Industry Association research management conference in New York. Algorithmic and direct market access trades have driven down commissions by 25 percent a year since 2002, Hintz noted, citing a report that said Wall Street lost $4.7 billion in equity commission revenue during the same period.
To attract those precious commission dollars, researchers must be perceived by buy-siders as experts in their respective industries. That provides veteran analysts with an opportunity to prove their mettle in a changing environment.
“Close relationships with managements are definitely a big part of the extra value I bring,” says Goldman, Sachs & Co.’s Lori Appelbaum, who is the first-teamer in Banks/Large-Cap and its precursor categories for an eighth year running. “Because I’ve known these people for a long time, I can pick up signs that they are starting to get interested in entering a new product area or geography. I can read their body language and confidence levels.”
The closeness pays doubly if company management uses the analyst as an intermediary for meeting investors, in turn increasing the brokerage flow that is now key to research compensation. Such matchmaking can be especially valuable for hedge funds because companies’ executives are often wary of their motives. “Some managements say they will not meet with hedge funds because they think that hedge funds misinterpret what they say, and then it’s all over the community in a few hours,” says BofA’s Morris. “That means we can act as a trusted conduit.”
Indeed, a rapidly growing source of commissions to the Street, hedge funds represent an increasingly important constituency for big research firms. And despite their reputation for rapid-fire, short-term-oriented trading, many appreciate the same back-to-basics, fundamental research that more-traditional clients value. That’s particularly true as the hedge fund industry matures and its needs converge with those of long-only money managers. Hedge funds now manage $1.3 trillion in global equities and account for roughly one third of equity brokerage commissions — an ocean of cash that can’t be channeled entirely into quick trading. An increasing percentage of that money is flowing into longer-term investments.
“The hedge funds’ research efforts feel very similar to what the large buy-side clients do now,” says Goldman’s Appelbaum. “If you didn’t tell me, I wouldn’t know they were hedge funds.”
“More and more clients are multistrategy,” says Lehman U.S. equity research chief Stuart Linde, adding that traditional, long-only managers also are catching up with hedge funds in this respect and are demanding trading options involving derivatives. “They don’t want the fundamental analyst writing the derivatives comment, but they do want an integrated product that offers them new ways to achieve alpha.”
Bernstein’s Hintz told SIA conference attendees that serving hedge funds will continue to be a top priority for investment banks, but he noted that two thirds of the U.S. prime brokerage market is controlled by just three firms — Bear Stearns, Goldman and Morgan Stanley — with the biggest and most creditworthy funds already being served. More profitable opportunities exist elsewhere in the world, and indeed, many firms are expanding overseas.
In July, Citigroup announced plans to hire 35 analysts to cover Brazil, Russia, India and China, and Merrill unveiled plans to double the size of its operations in Japan and hire analysts throughout Asia. One month earlier, UBS announced it was investing $40 million to open a new offshoring center in Hyderabad, India, that will employ a staff of 1,500 in research, analytics, data processing and IT infrastructure.
The universe of research consumers is expanding too. Of the 27,000 funds in the world, 2,500 were established in the past year, with most of the new additions being hedge funds that trade heavily and keep in-house staff light. “That’s a lot of competition for good ideas and a source of leverage for people who can establish themselves as thought leaders,” says UBS’s Steinert.
