Powerful changes are sweeping through equity research. Will Wall Street successfully adapt to a radically different environment?
By Justin Dini
October 2001
Institutional Investor Magazine
Even before September 11, the world of equity analysis was threatened.
The eight-year bull market that had made stars of a handful of researchers and merely enriched many others ended in March 2000. By early this year the U.S. economy was stumbling, making stock picking difficult. Analysts’ credibility plumbed new depths as they maintained buy recommendations on Internet and telecommunications stocks that in many cases had lost virtually all of their value. Investors filed lawsuits focused on the stock recommendations of well-known researchers like Morgan Stanley’s Mary Meeker and Merrill Lynch’s Henry Blodget. The media were full of stories about researchers’ conflicts of interest, ranging from investment banking entanglements to recommendations of stocks the analysts happened to own.
Regulators got into the act, too. Congress started its own inquiries. And the Securities and Exchange Commission instituted Regulation Fair Disclosure, which mandates uniform disclosure of corporate information to investors large and small. Its aim: to prevent companies from favoring certain analysts with potentially stock-moving news and insights that small investors weren’t privy to.
Wall Street research directors found themselves on the defensive on a number of fronts. Belated moves by major firms like Credit Suisse First Boston and Merrill Lynch to forbid analysts from owning the stocks they covered and to adopt industrywide best-practice guidelines addressed some of the concerns. And more change was expected.
Then came the terrorist attack on the World Trade Center, and analysts’ previous trials suddenly seemed trivial. Friends and colleagues at firms like Fred Alger Management, Cantor Fitzgerald, Keefe, Bruyette & Woods and Sandler O’Neill & Partners were lost; analysts at Merrill Lynch and Lehman Brothers, among others, were forced, quite literally, to run for their lives, and the entire U.S. stock market shuttered its doors for an unprecedented four days. It reopened with a thud, as the Dow Jones industrial average lost 14.3 percent of its value in a week, its worst performance since 1933.
Can Wall Street research recover its reputation and its footing? Yes. A changed world presents a whole new set of problems - and opportunities. Investors urgently need help in answering difficult questions. Is a global recession, or worse, at hand? What will become of the airlines? Travel and leisure companies? Automakers? The list goes on. Can technology surmount newfound security problems? Is the era of rip-roaring equity investment over for good? How should a prudent portfolio be restructured? These are the sorts of basic queries that equity analysis was originally intended to address. “Research becomes incredibly important,” says Alfred Jackson, head of global research at CSFB. “Our clients are seeing their portfolios getting pounded pretty hard, and their jobs are going to be on the line. They expect good, thoughtful, fundamental research in an environment like this.” Still, the drastic way in which the world has changed since September 11 may defy conventional equity analysis. Says Kevin McCaffrey, head of research at Salomon Smith Barney: “There’s so much economic and geopolitical uncertainty that many companies and sectors are practically beyond analysis. There is no historical reference point for what’s happened.”
The results of Institutional Investor’s 30th annual All-America Research Team attest to shifts already under way before September 11. There’s an unprecedented upheaval in the rankings (for which polling was conducted in May and June). Only one of the top ten firms retains its position from a year ago. That is J.P. Morgan Securities, whose tenth-place finish of 2000 remains unchanged.
Salomon Smith Barney leaps to the No. 1 spot from the third slot, with 55 total team positions, and CSFB, bolstered by its acquisition of Donaldson, Lufkin & Jenrette in November 2000, jumps to the second spot from fourth, with 52 positions. Merrill Lynch, which has occupied the top spot in II’s poll in each of the past six years, tumbles to third; Morgan Stanley, Merrill’s perennial challenger and last year’s co-leader, slides even further, to fourth. Goldman, Sachs & Co., meanwhile, drops out of the top five altogether, landing in seventh place. Replacing Goldman is Lehman Brothers, which climbs to fifth place from eighth.
The ferment extends to individual analysts. Morgan Stanley’s Meeker, the analyst most publicly identified with the 1990s technology-driven bull market - and the subsequent bear market - fell to second place in our Internet rankings a year ago. This year, feeling the wrath of singed investors, the four-time first-teamer does not make the rankings at all. Lehman Brothers’ Holly Becker, a former No. 1-ranked cosmetics and personal care products analyst at Salomon Smith Barney who, on assuming Internet coverage, took a more critical view of the sector (newly renamed Internet Portals & Commerce for 2001) jumps into first, displacing Merrill’s Blodget, who falls to third.
These are only the most noticeable shifts in technology research leadership, where a number of perennial first-teamers have paid the price for the sector’s poor performance. Several lesser-known analysts have surged forward. Although he still takes top honors in Competitive Local Exchange Carriers, Salomon Smith Barney’s Jack Grubman, one of the Street’s most recognizable and highly paid analysts, drops from first to third in Wireline Services. He is succeeded in the No. 1 spot by Daniel Reingold of CSFB. In PC Hardware Richard Gardner of Salomon Smith Barney, a runner-up a year ago, jumps up to take the top spot from UBS Warburg’s Donald Young, who falls to third. And Jonathan Joseph of Salomon Smith Barney leaps into the No. 1 position in Semiconductor Devices, where he was a runner-up a year ago.
The change in investor attitude can also be seen in Portfolio Strategy. Abby Joseph Cohen, Goldman Sachs’ well-respected strategist and a relentless bull in the late 1990s, fell from first to third a year ago. This year she drops further to runner-up. On top? Sanford C. Bernstein & Co.'s Michael Goldstein, a 2000 runner-up who has been cautious about equities.
That’s not to say that there isn’t plenty of continuity in this year’s team. Ed Hyman, chief economist at International Strategy & Investment Group, takes the top honors in his discipline for the 22nd time in a row, tying the all-time record. And longtime first-teamers Richard Sherlund of Goldman Sachs (Applications Software) and Charles Phillips Jr. of Morgan Stanley (Enterprise Software) remain No. 1 in their specialties.
Still, changes in Wall Street research can’t seem to come soon enough for many investors. Despite major firms’ attempts to increase the number of sell recommendations and limit, or at least disclose, their analysts’ stockholdings, they clearly have much more work to do. In a survey that accompanied our All-America Research Team polling, 63 percent of portfolio managers, buy-side research directors and equity analysts maintain that they don’t trust sell-side research. Nearly 40 percent of respondents say that the quality of research has deteriorated in the past 12 months; just 10 percent say it has improved. On a scale from 1 to 10 (with 10 the best rating), respondents give Wall Street research a middling 5.65 (down from 5.9 last year).
That sense of distrust and disappointment has not been lost on Wall Street. “You would hope, in light of the criticism this year as well as the downturn in the markets, that you’ll see analysts go back to basics,” says CSFB’s Jackson. “We need to go back and actually do some real work. I truly think we need to go back to some of the things we did a long time ago.”
Will that include a more independent form of research? Some believe so. “I think that as a result of all this, you will see what Donaldson, Lufkin & Jenrette did decades ago - research for the sake of research,” says Alan Benasuli, a six-time first-team aerospace analyst who now runs money for New York-based European Investors (see story, page 104). “Independent boutiques will not make the tons of money that Goldman Sachs and Salomon Smith Barney and Morgan Stanley make, but I think there will definitely be a sector of the buy side which will pay for these unvarnished opinions.”
II’s polling offers Benasuli some support. When asked to rate on a scale from 1 to 10 (10 being the highest) the extent to which analysts’ corporate work creates a conflict of interest, respondents on average put the conflict at 8.25. A huge majority - about 74 percent - say they would be willing to pay more for research deemed independent from corporate finance. After industry knowledge and accessibility, investors rank independence from corporate finance as one of an analyst’s most crucial attributes. Earnings estimates and stock selection, the most public of a researcher’s duties, are near the bottom of that list.
Some, though, are skeptical about the prospects for independent research firms. “I don’t know how that kind of independent research is going to be paid for,” says Jackson. “Institutions haven’t paid for it in 28 years, and I don’t know that they are going to start now.”
All of the carping about Wall Street research overlooks the exceptional work done by some analysts in the past year. For example, Lehman Brothers’ top-ranked Wireless Equipment analyst, Tim Luke, downgraded Nortel Networks Corp. last October at 67 - in late September the shares were hovering at just over 5. Steven Binder, the first-teamer in Aerospace & Defense Electronics at Bear, Stearns & Co., recommended defense contractor Lockheed Martin Corp. in April 2000 in part because he anticipated higher defense spending. By August it was up 70 percent, to 39. In the aftermath of the September 11 attacks, Binder’s call stands up: Lockheed Martin shares were trading near 45 later in the month.
Picking the team
To select the members of this year’s All-America Research Team, Institutional Investor sent questionnaires covering 79 industry groups and investment specialties to the directors of research and chief investment officers of major money management institutions. Included were those managers on the II 300, our July ranking of the largest institutions in the U.S., as well as other key U.S., European and Asian investors. Directories and industry data sources were tapped to ensure that the survey universe was complete. We also contacted key institutional clients from lists submitted by Wall Street research directors and sent questionnaires directly to analysts and portfolio managers at many top institutions. In total we mailed ballots to more than 780 institutions.
Rankings were determined by using the numerical score each analyst received. Scores were produced by taking the number of votes awarded to an individual analyst and weighting them based on the size of the voting institution and the place that the respondent awarded to the analyst (first, second, third or fourth). For Convertibles, Quantitative Research/Equity Derivatives, REITs and Washington Research, votes for all analysts covering those fields at each firm were combined; in the commentary we then highlighted the head of the team effort.
To meet this magazine’s production schedule, analysts who changed firms after August 6 are cited at their previous organizations. Several analyst moves took place after the cutoff. For example, Frank Bodenchak, the winner in Radio & TV Broadcasting, left Morgan Stanley in mid-August to start a hedge fund; William Pecoriello, the second-teamer in Beverages, left Sanford C. Bernstein & Co. to join Morgan Stanley.
Sectors are organized into broad industry groups: Basic Materials, Capital Goods/Industrials, Communications (renamed from Telecommunications), Consumer, Energy, Financial Institutions, Health Care, Media, Technology and Macro. The sectors were determined by Institutional Investor in consultation with buy-side and sell-side research directors.
We’ve made a few changes to the individual sectors this year to reflect the changing economy. Data Networking and Wireline Equipment, which formed a single category a year ago, have been divided into separate sectors this year. Treated separately in 2000, Quantitative Research and Equity Derivatives have been joined, as have Autos and Auto Parts. This year we’ve created an Internet Portals & Commerce sector that joins last year’s E-Commerce and New Media categories; PC Software has been rechristened Applications Software, and Business Services has been retitled Business & Professional Services. Education Services has been dropped.
The identities of the survey respondents and the institutions that employ them are kept confidential to ensure their continuing cooperation. The opinions of more than 3,200 individuals - representing approximately 90 percent of the 100 largest U.S. equity managers, as well as more than 300 other key money management firms - were tapped.
Our reporters spent weeks talking to voters to learn more about the analysts they had selected. Many of the winners were also contacted to clarify points their clients raised and to confirm certain stock prices.
Here, then, is our ranking of the best brokerage firm analysts in 79 investment areas. It was compiled by Institutional Investor staff under the direction of Senior Editors Carolyn Sargent and Jane B. Kenney with Associate Editor Sivert Hagen and Assistant Editor Erika Ihara. Staff Writer Justin Dini wrote the introduction. Reporter/Researcher Suzanne Lorge and Contributing Editors Pam Abramowitz, John Belmonte, Andrew Bloomenthal, Jeanne Burke, Mary D’Ambrosio, Mary Dubas, John Hintze, Ben Mattlin, Ellen James Martin, Scott McMurray, Donna Mitchell, Giles Peel, Mike Sisk, Miriam Stickler and Alison Zomb wrote or edited the sector reports that follow.
Click here to go to IIPlatinum’s exclusive research & rankings database to view the complete 2001 All-America Research Team results.
