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 wasnt 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 hed 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 Reingolds 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 didnt even attempt to debate Reingold and casually told him hed verified the information he used by running it past a buddy at AT&T. Now Im 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 didnt last long. The first blow to the research industry was the SECs 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 didnt 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 didnt think so much that what they were saying was subject to oversight by regulatory authorities, because it wasnt. Surveys of institutional investors, including IIs 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 couldnt 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 isnt going to move prices, the Wall Street executive says. By contrast, if a mutual fund, pension fund or hedge fund buys something, theyre making a judgment about valuation, and its 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, were 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.