The New Old-Fashioned Research

After five years of unprecedented turmoil, today’s elite Wall Street analysts are succeeding by going back to basics with rigorous, hard-hitting research.

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The idea behind investment research is deceptively simple: Gather lots of information about a stock, bond or some other security, analyze that information, and decide whether to buy or sell. Such calculations are as old as investing itself.

In practice, however, doing top-notch research is anything but easy. Rarely has that been more evident than over the past five years as regulatory pressures, market turmoil and budget cutbacks have made life more and more difficult for the men and women who research stocks for Wall Street’s major brokerage houses.

Once among the highest paid, best known and most influential people in finance, analysts have had their wings clipped in recent years as a result of conflict-of-interest scandals. In 2001, New York State Attorney General Eliot Spitzer began an investigation that focused on analysts’ willingness to compromise their objectivity to please their firms’ corporate clients. Congress also convened hearings on the matter. Spitzer’s probe culminated in a $1.5 billion settlement with 12 big brokerage firms. That pact imposed a bevy of new rules, designed to limit the influence of investment bankers on analysts, that have profoundly altered the practice of investment research.

During this time analysts also have faced massive dislocation in the stock market as one of the biggest speculative bubbles in history turned into a deep bear market — one that was exacerbated by the 9/11 attacks and a string of staggering corporate frauds involving the likes of Enron Corp. and WorldCom that few analysts saw coming. Securities firms have responded to the economic and regulatory pressures by slashing research staffs and budgets.

The bottom line: Analysts today face more bureaucracy, less respect, diminished influence and lower pay.

“Analysts have had to deal with a lot during the last five years,” says David Maris, who covers specialty pharmaceuticals stocks at Banc of America Securities. “It’s still a very rewarding job, but it definitely hasn’t been easy.”

Through all the investigations, negative press commentaries, structural industry shifts and market swings, a select group of researchers has managed to not only cope with change but stay at the very top of their profession — even as scores of their peers have fled for hedge funds, corporate jobs and other seemingly greener pastures. This year we shine a spotlight on these standout performers in Institutional Investor’s 35th annual All-America Research Team®.

Nineteen of the 320 analysts ranked in this year’s survey have been voted No. 1 in their sectors for at least five consecutive years. Some, like Merrill Lynch’s Steven Fleishman and International Strategy & Investment Group’s Ed Hyman, have topped their categories for a decade or longer. Eighteen of these 19 analysts are highlighted in the photographs accompanying our ranking. (Morgan Stanley telecom researcher Simon Flannery was unavailable.) The work of these analysts is characterized by dogged, independent, sharp-eyed analysis that takes with generous portions of salt the proclamations of CEOs and CFOs. It demands extensive fieldwork and attention to the interests of investing clients above all else. Often it also entails considerable personal courage and legal risk. Maris, for instance, is being sued by a company that he slapped a sell rating on.

Call it the new old-fashioned research.

“The changes we’ve seen in the last five years have in many ways led to more-rigorous research,” says Lehman Brothers researcher Timothy Luke, whom survey voters have awarded the top ranking in the Telecom Equipment/Wireless category for seven consecutive years. “Today you have to get your information not so much from the company but from the people acting around the company — the suppliers, the customers, the competitors. That’s a very healthy thing for the future of research.”

So much has changed since research as we know it today first began to take shape. Back in the 1960s pension funds, mutual funds and bank trust departments began amassing huge sums of money on their way to supplanting individuals as the dominant force in the stock market. These institutions looked to the brokerage houses that executed their trades for ideas to help them outperform the market. Pioneering firms like Donaldson, Lufkin & Jenrette hired analysts to conduct fundamental research into companies and to provide ideas to brokerage clients. By the early 1970s every major brokerage firm on Wall Street recognized the importance of research, as did we at II in publishing our first All-America Research Team in October 1972.

Much has changed since the first survey, which ranked Oppenheimer & Co. as Wall Street’s first research powerhouse. Congress deregulated brokerage commissions in 1975, triggering a dramatic decline in rates that forced small research shops like OpCo, Mitchell Hutchins and Wm. D. Witter into the arms of bigger houses. As commission rates continued to shrink during the 1980s and ’90s, investment banking fees became the new economic foundation supporting ever-bigger and more-expensive research departments. That gave rise to well-documented conflicts of interest, with analysts frequently joining investment bankers in advising CEOs on deals and strategy and often issuing glowing reports to curry favor with corporate clients.

Today it’s back to the future as analysts once again are focusing on fundamental research. But, as ever, doing so is not easy. Consider Maris, a first-teamer in his sector for six years running. In February, after he advised clients to sell the shares of Biovail Corp., the drugmaker named him as a defendant in a lawsuit alleging that analysts and hedge funds conspired to drive down its stock price. “To do this job, you have to be willing to stand by unpopular opinions, and that isn’t always the most comfortable thing,” says Maris, who along with BofA has vehemently denied Biovail’s allegations but declines comment on specifics while the case is pending. “You have to have a stomach for it. You have to have a thick skin.”

When we asked these featured researchers what has changed the most over the past five years and how they have thrived during this period, one refrain echoed loudest: Stock picking and ideas matter again, as pressure from investment bankers for coverage and positive ratings has abated. Another reason that ideas once again are paramount in research departments: the rise of hedge funds, which often trade more frequently than traditional mutual funds and pension managers, as Wall Street’s most important client base.

Notwithstanding their accomplishments, some of our repeat winners bemoan the diminished stature of sell-side analysts. Fleishman, the top Electric Utilities researcher for the past ten years, says the job is less appealing because of regulations that make it more difficult for analysts to have a full, free-flowing relationship with CEOs of the companies they cover. Fleishman, who last month retired from Merrill, once engaged in high-level conversations with chief executives about corporate strategy and potential deals. Now, because of new rules — most significantly, the SEC’s Regulation Fair Disclosure, which prohibits public company executives from revealing material information to select recipients — CEOs are far less likely to ask stimulating questions of analysts.

“The job became much simpler in the post-Spitzer era,” says Fleishman, who adds that he is interested in starting his own investment fund after taking some time off to spend with his family. “But we also became less relevant. You’re no longer the center point of activity in your sector.”

The new regulatory regime also has introduced bureaucratic hurdles — such as requiring that internal committees and compliance departments sign off on written reports, ratings changes and new coverage — that make it more difficult for analysts to get their ideas to clients in a timely manner. That’s especially significant in a world of ever-faster communications, where lost seconds can cost investors big money.

Today’s elite analysts are embracing the new era. The researchers who will prosper most in this environment are the ones who are motivated by the less glamorous aspects of the job. They enjoy digging for obscure details in financial statements and uncovering critical facts about company prospects by poking around retail stores, ports, warehouses and other places of business. They love to massage all of this data to build a case for or against a particular investment. And they are focused exclusively on providing ideas that help investing clients make money.

“During the Internet heyday there were lots of people coming into this business that were both unqualified and in here for the wrong reasons,” says Maris. “A lot of those people skated by on innuendo and hearsay, and the job has changed dramatically for them. But if your focus is to ferret out original information and to be relevant to investors, then the job hasn’t changed that much at all.”

“If you’re coming into this job today, you’d better make sure that you really love the intellectual challenge,” adds Citigroup analyst David Raso, who has won the top spot in the Machinery sector for the past six years. “The frivolous or vain aspects of the job that existed five or six years ago are long gone.”

That should bring a smile to the faces of research pioneers like DLJ co-founder William Donaldson, who as SEC chairman from 2003 to 2005 tried to clean up his old profession. During DLJ’s early years, Donaldson once posed as a dentist at an industry conference to extract information about a medical supplier’s new tooth drill. He called it the “scuttlebutt method.” Such shoe-leather research worked back then. Today it’s more important than ever.