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The pioneers

When Dick Jenrette, Bill Donaldson and Dan Lufkin began offering independent analysis of companies to institutions in 1959, they revolutionized stock research. Here's what they think of it now.

When Dick Jenrette, Bill Donaldson and Dan Lufkin began offering independent analysis of companies to institutions in 1959, they revolutionized stock research. Here's what they think of it now.

By Justin Schack
October 2001
Institutional Investor Magazine

There was a time, not so long ago, when nobody knew who Wall Street analysts were, what they did, or what they got paid (not a heck of a lot, by today's standards). Researching stocks was something prudent investors did for themselves, although the so-called wire houses like Merrill Lynch, Pierce, Fenner & Smith did perform rudimentary statistical analyses of companies for the benefit of unsophisticated investors.

Three young Wall Streeters who had gone to Harvard Business School together - William Donaldson, Daniel Lufkin and Richard Jenrette - sensed that there was an information void on Wall Street. And an opportunity. Single-handedly or, more accurately, triple-handedly, they created the sell-side research industry as we know it today.

In 1959 the three founded Donaldson, Lufkin & Jenrette on a simple, but compelling and audacious, business model: Give institutional investors well-researched investment ideas, and you will attract their brokerage business. As it happened, their market timing was pretty good. The extraordinary bull market of the 1960s - the go-go years - was about to get under way and with it a boom in stock research. DLJ effectively transformed a genteel Wall Street club, in which information consisted of whispered confidences, into a marketplace of ideas.

"People were doing research long before DLJ, but they made it a business," says Jack Rivkin, an executive vice president of Citigroup Investments who started as a sell-side analyst in 1968 with Laird and built up Shearson Lehman Hutton's research department during the late 1980s. "DLJ put out these 40-page reports that no one had seen much of in modern times, and people were reading them and making money," Rivkin recalls. "They were the first ones to really realize the power of providing institutional investors with good ideas, and a lot of people followed them and did the same thing."

Bill Donaldson, who was working at the time for G.H. Walker & Co., the Wall Street brokerage run by President George W. Bush's great-uncle, had the insight that institutional investors would become the dominant force in the market. At the time, institutions accounted for just 30 percent of New York Stock Exchange volume, but some of today's great fund families were just starting and corporate pension funds were beginning to move into the stock market. Once DLJ got launched, Donaldson pushed his fellow founders to buy a seat on the NYSE and focus on capturing institutional orders. By the end of the 1960s, institutions were contributing 70 percent of volume.

Dan Lufkin, employed in pre-DLJ days by investment manager Jeremiah Milbank, was much influenced by the writings of growth investors like T. Rowe Price, Thomas Brittingham and Philip Fisher (who later would become a DLJ analyst). Lufkin came up with the idea of producing in-depth research reports on small companies, patterned after the analyses of case studies he had done at Harvard.

DLJ's very first research report, released in December 1959 and titled "Common Stock and Common Sense," contained no buy, hold or sell recommendations; rather, it was a manifesto that laid out the firm's philosophy of investing in smaller companies that it promised could deliver consistently superior earnings growth at a reasonable stock price. Detailed reports on specific companies would soon follow: Haloid Xerox, Diebold, Alcon Laboratories.

This was a sharp departure from Wall Street convention. In those days most investors and brokerage firms were concentrating on big, blue-chip stocks with high price-earnings ratios: the so-called Nifty 50. DLJ's founders believed that institutions would reward them for identifying promising companies by directing trades their way. With commissions fixed at far higher levels than today's negotiated rates, this model had great potential.

But starting a new firm on old-boy-dominated Wall Street was just not done in those days. "In 1959, when I was at Brown Brothers Harriman and told them I was starting a new firm," recalls Jenrette, "they said, 'Dick, don't you know that there have been no new firms since 1932?' But that in itself certainly suggested a need for one."

When they started DLJ, Donaldson and Lufkin, who had been classmates at Yale, were 28. Jenrette, a North Carolinian educated at the University of North Carolina, was the elder statesman of the group at 30. The three borrowed $100,000 in seed capital from chums and associates - a sizable amount at a time when new Harvard MBAs earned about $7,000 - and opened for business at 51 Broad Street in December 1959. Among DLJ's corporate objectives: "To have fun."

As the firm's founders, proprietors and sole employees, all three assumed the role of analyst. Doing qualitative as well as quantitative research, they gathered data about a company not just from the treasurer's office but also from competitors, suppliers and former employees. The formula worked spectacularly, and DLJ's success ushered in a golden age of Wall Street research.

Scores of brokerage firms launched institutional research departments, and the best analysts went on to achieve great influence on Wall Street and beyond. Benjamin Rosen, who had followed electronics companies as an analyst for Coleman & Co., helped start Compaq Computer Corp. Goldman, Sachs & Co. analyst and later research director Leon Cooperman today runs a $3 billion hedge fund complex, Omega Advisers. And a rising - but often wrong - economist who had a consulting arrangement with Morgan Stanley's research department went on to become Federal Reserve Board chairman Alan Greenspan.

In 1970 DLJ became the first New York Stock Exchange member firm to go public. The prospectus revealed how profitable good research could be: DLJ was earning a return on equity of more than 50 percent.

At about this time, retail brokerage heavyweights as well as investment banking powerhouses were awakening to the bankability of star analysts. Former Merrill CEO and Treasury secretary Donald Regan led the charge. By luring top analysts away from research boutiques, Merrill was able by 1976 to land atop this magazine's analyst rankings. Meanwhile, Morgan Stanley hired Barton Biggs, then at hedge fund A.W. Jones, to create from whole cloth its research and money management department. "Morgan Stanley had a planning session in 1973 in which it was decided that things were changing, and that the firm could not just be a pure investment banker," says Biggs. "Even though we had this wonderful list of blue-chip clients, eventually we were going to lose them unless we could distribute securities as well as underwrite them." Morgan Stanley, too, emerged in short order as a research power.

But even as the economic value of producing research became clear to Wall Street, the early good times were drawing to an end. On May 1, 1975, brokerage commissions were deregulated. Discount brokers began competing on price, and institutions were only too happy to take them up on their cut-rate offers. Compounding a prolonged bear market, May Day turned a difficult business climate into a deadly one. Many of the top research houses either went under or succumbed to shotgun mergers. Others struggled to find alternative revenue sources, such as investment banking or money management. (DLJ ventured into both.) Only the biggest firms, those with diverse revenue streams, could afford to pay the kind of top-rated analysts who attracted commission dollars. Before long, research became a loss leader rather than a revenue driver.

Yet at the same time, investment banking was booming. Indeed, at most firms investment banking fees began to indirectly pay the bulk of analysts' salaries. (They still do.)

The situation became ripe in time for all the abuses of the '90s. Starting with the August 1995 IPO of Netscape Communications Corp. - which ignited the technology and Internet IPO boom - companies, especially technology companies, issued new securities at an increasingly frenzied pace. Firms came to prize research chiefly for its ability to attract corporate clients. CEOs wanted to see favorable research reports that would boost their companies' stock, and all too often they decided which investment banks to hire based on how accommodating those firms' analysts were. This threatened analysts' independence.

Even before the Internet collapse, complaints about the quality of research were mounting. Roughly 40 percent of money managers polled in late spring 2001 by this magazine said research had declined in quality over the preceding year. Critics groused that analysts did nothing more than parrot the rosy projections of company executives, doing little independent research to challenge the company line.

Challenging assumptions was precisely what DLJ strived to do, of course. And although its founders haven't been involved in sell-side research for some time, they still have strong opinions about how it's being conducted and how it should be conducted.

"We don't want to be known as the fathers of the kind of research that's being done today," declares Jenrette. "When we were starting out, we rebelled against statistical, simplistic research reports. And now all you read is that a company's profit margin declined by so much, that it's at 120 percent of the S&P average. It's all statistical. I read research and I can't even find out what a company does half the time. There's no effort to explain what its competitive edge is. It's not qualitative, it's all computer models."

To be fair, the standing of Wall Street research rises and falls on a regular basis, usually along with the stock market. Listen to this angry fund manager quoted in a 1970 Institutional Investor cover story: "Can Wall Street Research Shape Up?": "A bear market sure shows you the quality of Street research, and I tell you, it's terrible. You get these fat reports on a company, and then the earnings come in 40 percent less than predicted. You call the analyst and he doesn't know a thing. All he's done is report what the company told him."

In time DLJ's three founders all went on to other things. Donaldson left in 1973 to serve as undersecretary of State in the Nixon administration. He never warmed to Washington and left the capital in 1974. The following year he became the first dean of the Yale School of Management. During the 1980s he ran a low-profile private equity shop before serving from 1990-'95 as chairman of the Big Board. In 1999, after insurer Aetna fell on hard times, longtime director Donaldson took over as CEO, stabilizing the company while finding a successor.

Lufkin also went into public service, leaving DLJ in 1971 to serve two years as Connecticut's first commissioner of environmental protection. He has remained an active investor in private and public companies, most notably as a general partner with GKH Partners, one of the investment vehicles of Chicago's wealthy Pritzker family. In 1995 Lufkin and turnaround specialist Jay Alix co-founded Questor Partners, a $1.1 billion private equity investment firm.

Jenrette ran DLJ until 1986, when John Chalsty, a Harvard Business School classmate he had recruited in 1969, succeeded him as CEO. The year before, Jenrette had sold DLJ to Equitable Life Assurance Co., which operated the firm as an independent unit, with Jenrette agreeing to stay on as chairman. When Equitable got into trouble, the board in 1989 asked Jenrette to turn DLJ's parent around. It took him several years to do so, but he was able to retire triumphantly in 1996. Credit Suisse Group acquired DLJ last year and merged it into Credit Suisse First Boston.

Speaking of research

The three founders of Donaldson, Lufkin & Jenrette - William Donaldson, Daniel Lufkin and Richard Jenrette - pioneered modern-day Wall Street research. This summer Institutional Investor Editor Michael Carroll, Senior Editor Hal Lux and Senior Writer Justin Schack sat down with all three to discuss the state of research - then and now.

Institutional Investor: What was the idea behind Donaldson, Lufkin & Jenrette?

William Donaldson: Our basic concept was that the ranks of institutional investors were growing and they were going to need more than statistical research. They were going to need qualitative judgments, particularly in an area that we thought was attractive in 1959: small companies. So we set out to provide research that was a lot closer to what a [consulting firm like] McKinsey & Co. would do than what was being turned out by Standard & Poor's - much more in-depth, intensive. We were much more interested in things like what a company's philosophy was and how its sales force was organized - in-the-field research on how things were going - than we were in what management said was good about their company. We tried to make up our own minds.

Why emphasize small companies?

Donaldson: At the time, the S&P 500 was selling for 21 or 22 times earnings, and all the Generals - you know, General Motors, General Foods, General Mills and so forth - were selling at fancy multiples but only growing at 7, 8 or 9 percent. There was this whole class of companies that were smaller but leaders in their industries.

Daniel Lufkin: Other firms that did in-depth research focused on markets where they felt they could get paid - on stocks like Con Edison or Edison Electric that were big enough so that banks and insurance companies could make a significant commitment to them. The names we focused on were less than $50 million in market cap. Even if you were paid by fixed commissions - which were handsome - if you couldn't do any volume, you couldn't get paid much.

Richard Jenrette: Later on more people were interested in small companies. But the real payback we got was not from people buying a stock we recommended, as it was at other brokerages. Money managers wanted to get our research. They were doling out a growing heard of fixed commissions, and they would just send some our way.

Lufkin: I'll never forget going into Allstate Insurance, visiting Bill Malone. We hadn't talked but 15 minutes and he called his trader and said, "There's a new firm that's called . . . what . . . how do you spell Jenrette? It's Donaldson, Lufkin & Jenrette." He said, "Okay, buy 10,000 shares of Cities Service." That was his way of saying, "Thank you for doing innovative research."

Donaldson: Our pitch was, the best thing we can do for you is give you enough information so that you will hold a stock like Xerox for the long haul. We didn't care if people bought specific stocks through us, just as long as they paid us a stream of brokerage dollars based on the quality of the ideas we gave them.

Did companies object to being scrutinized in this new, intensive way of yours?

Jenrette: They welcomed us with open arms. Nobody was covering them. We were the only one coming in, initially.

What kind of salary did you pay your first analysts?

Lufkin: It was a wonder we paid ourselves.

Jenrette: A big $6,500 a year.

Lufkin: No, it was $7,200.

Jenrette: That's what I made at Brown Brothers, though - $6,500.

Donaldson: Dick wouldn't come join us without a raise.

Even in those days, weren't there conflicts of interest in research?

Donaldson: The potential conflict we faced was money management. We always asked ourselves, Well, if we've got such great research and we've got such great investment results, why are we selling it for brokerage dollars when we could be managing money ourselves? So we decided to form Alliance Capital Management, which became our investment management subsidiary. But that posed a potential conflict. We had long debates about whether clients would stop dealing with us if we started taking investment management accounts from them.

Jenrette: That's why we changed the name to Alliance. We got tired of being taken to the woodshed by Chase Bank. We decided to give it a different brand name, and somehow that made a difference.

Donaldson: Also, every time we sold a pension fund account, we had to answer the question, "Aren't you guys just going to trade my account? You're in the brokerage business." And we basically replied that that would be cutting off our nose to spite our face. If we don't have the investment record, then we're going to lose you as an account. That conflict forced us to do less and less of Alliance's business with Donaldson Lufkin, and more with other firms.

Jenrette: After ERISA was passed in the mid-'70s, it was considered bad form for a broker to manage money. And the banks came out of their caves and made another play for fiduciary responsibility.

Lufkin: If you look at all of the relationships in financial services today, there are conflicts everywhere. You can't turn a page, you can't take a step, without running into a conflict. If you try to legislate against it, you're legislating morality.

One big criticism of research now is that it is unjustifiably positive. Did you put out a lot of sell recommendations on stocks back then?

Lufkin: There's no logic to doing research on a lousy company. There's no market in selling a lousy company. There's a great market in buying an excellent company. So we concentrated on where the markets were: excellent companies.

Donaldson: But if something went wrong in one of our companies, if there was a hiccup where the company didn't do what we said it was going to do, we tried to create a market between people who wanted to get out and those who wanted to take advantage of that hiccup and get in. We didn't just say, "Sell this stock."

Lufkin: There was a company called Permian, which was in oil gathering in Texas. Permian fell on its face for a number of reasons, and we had a lot of people in it. We told our clients: "This thing is not going to work for a period of time. Do what you want with it. The oil markets are not going to be great, they're not going to make any money. If you want out, we'll get you out. We don't know at what price. But if you want to stay with it, we think that the strategies of this business are right over a five-year period." But there was no reason to issue a 50-page sell report on it. This gets back to what has happened to research. An analyst is not appraised on how smart he is in five years. He's being appraised on a three-month accounting period.

Is this because there are many more retail investors in the market or because institutions are trying so hard to beat the market?

Donaldson: Part of it is press coverage. There's this inane quarter-to-quarter attempt to predict earnings - down to the final penny. On the company side you have a conference call, and everybody's got their models. And all you do is give them the numbers, and they put them in their models, and if earnings per share is pennies below what the models say it's going to be, the stock tanks. This isn't research at all.

Jenrette: Wall Street analysts have been seduced by spin doctors at corporations. They're not doing the basic homework. Dan found that there was this thing we called the scuttlebutt technique, where you learn most of what goes into your reports not by getting it from the company but by talking to competitors, customers, former employees and such.

Donaldson: There was this dental supply company up in Rochester that made a new high-speed drill. And Dan and I went to a dentists' convention here in New York, posing as-

Lufkin: Dr. Donaldson!

Donaldson: Right. Dr. Donaldson and Dr. Lufkin.

Lufkin: We got found out after about two seconds. Donaldson was drilling a tooth and they said, "That doesn't look too good. That's not a dentist's work."

Donaldson: But the point is, we were able to gauge the reaction among the dentists there, and say, "It's a crock, it's never going to go." You wouldn't have gotten that from the company.

Where do you see research heading?

Lufkin: I see a major conflict on the horizon involving the power of the commercial banks to take away investment banking business from the firms that have traditionally controlled it.

Jenrette: The remaining independent investment banks are going to be forced into marriages with commercial banks, because companies today want somebody who can provide the whole thing - short-term capital, long-term capital, bonds, loans.

Donaldson: And the number of major players will drop to perhaps five or six in this country and maybe three abroad, or ten globally. They're going to be so big and so conflicted that there's going to be a whole middle market of little growth companies that can't get to them. So what will happen is that you'll see a lot of spin-offs from big investment banking firms. People will reinvent the wheel and get into the financing of these companies. This business has an amazing ability to reinvent itself. And these firms will do really good research - not commodity research but really good investment ideas.

Jenrette: A really good investment idea is worth a lot. If you correctly analyze something that nobody else is on top of, you will get paid for it.

You guys were Young Turks when you started. Did you have trouble establishing credibility?

Jenrette: The reports spoke for themselves. They were so detailed.

Donaldson: We were dealing with smaller companies, but these were not just business plans. These were going companies. You know, Dun & Bradstreet, A.C. Nielsen, Diebold - the safe company. They were leaders in their industries. With the dot-com craze, you had so many of these young guys, even younger than we were, with just a business plan. Just an idea.

Jenrette: Another thing we did to get credibility was to introduce the concept of the analyst-salesman. Wall Street had what we called martini-drinking salesmen who interfaced with the client, and we tried to bury the martini drinking. We didn't have a sales force right away. So our analysts not only wrote these impressive reports, but they were also out talking to clients.

What lessons do you draw from the market blowup?

Jenrette: I've seen my share of bubbles, but the Internet thing was the worst I've seen in 45 years.

Lufkin: What troubled me was that research took the form of estimating market value. You know, what's-his-name [Henry Blodget of Merrill] is listed as a great analyst. But he said Amazon would go from 250 to 400 within whatever period. It in fact did, and he's written down as a genius. But it had nothing to do with an analysis of what went on at Amazon.

Jenrette: The unsophisticated investor who was new to the market - that was the seedbed that allowed this bubble to happen. The pros knew it was ridiculous, but they were either making so much money they ignored it or else they were programmed to keep plowing ahead because of a narrow definition of what their expertise was, like a technology-specific fund.

Donaldson: That gets back to today's short-term performance orientation. And even the, quote, "pros" couldn't afford not to get on the bandwagon. Three years ago who could afford to have the telecom stocks doing what they were doing without having a piece of the action?

Lufkin: But while this blowup was more focused and more extreme, what about the Nifty 50 in the early '70s? I'll bet more money was lost by institutions in the Nifty 50 than was lost in the Internet.

Do individuals have the tools to manage their own money?

Donaldson: A woman once came into DLJ, a widow who had a portfolio. Said she had done so well that she was getting a bit scared and wanted to turn it over to someone professional to manage. So we asked her: "You know, you have got a good bunch of stocks in this portfolio. How have you managed to pick such good stocks?" And she said, "Well, I had a system. I read Life magazine, and I kept a chart of the advertisers. A company went on the chart when I saw their first ad. And then if they survived for a full year and were still advertising, they moved up on the chart. And then in the second year, if they were still advertising, I bought some of their stock. If they were still advertising in the fourth year, I bought some more stock."

It wasn't scientific, but she had a system. If a company had a big, splashy ad but was out of the magazine the next time, it was a fly-by-night. If somebody could pay those rates for three or four years, it was a solid company. So can an individual do the kind of analysis that Wall Street is turning out? I don't know. But can they delve into the scuttlebutt system? Can they look at companies in their neighborhood? Sure. Somebody attuned to looking at what was happening at Home Depot might think it had been a pretty good investment.

Now companies are playing games with their forecasts because they're so desperate to meet quarterly expectations. This is counterproductive. No company that plays those games can run itself properly. Real analysis projects over a longer period. Nothing grows the way analysts would have it grow. That's only an artifact of accounting. Children have growth spurts, and it's the same with companies.

What's your opinion of Regulation FD?

Donaldson: It's crazy in terms of what it does to the free flow of information.

Jenrette: I beg to differ with you, in the sense that I hope it forces analysts to stop being slaves to corporate spin doctors and go out and use some scuttlebutt techniques - talking to customers, suppliers and getting the real story about companies.

Donaldson: But you can't create what you've created now, which is this giant blackout.

Jenrette: Blackout? We're flooded with information. I've never seen so many corporate announcements.

Donaldson: Dick, I know. There is stuff going on in a company and nobody can talk about it. The company can't talk until their next reporting period, and they can't mention something that's going wrong unless they blast it to the world. It is paralyzing communications between analysts and companies. It's a terrible rule.

How would you solve the current problems of research?

Lufkin: I'd like to see analysts not be so forgiving of companies who take these huge writedowns to earnings. It's really ridiculous - it doesn't matter if you write down $2 billion or $3 billion or $40 billion - analysts are excluding it as "extraordinary," and the companies aren't being penalized by the market for what quite often are operational issues. They are letting the companies get away with murder.

Jenrette: What I think should be done isn't going to happen, and that's to bring back Glass-Steagall. Abolishing it was a terrible mistake. We have already seen how, one by one, good research departments were subsumed by investment banking. Now we're going to see creative investment banks being taken over by big banks, using government-guaranteed deposits. The last to go will be the venture capital firms.

We used to think banks shouldn't own stocks. Why? Because they are taking people's deposits. And we saw what happened in the 1929 crash and the Depression. But now no one bats an eyelash when Morgan Chase writes off billions in venture capital investments. Isn't that evidence that banks taking deposits shouldn't be making investments like that? There are real conflicts of interest, and you have to have some barriers. I'm not a total laissez-faire capitalist. Capitalism has worked so well for so long, we have forgotten that we took the hard edges off of it. We're bringing some of the hard edges back right now, and we're going to regret it.

Donaldson: Politics is just one of the areas where we don't always agree.

Jenrette: A good firm always has both sides.

Donaldson: But getting back to the question, we have firms that are now politically saying: "We won't let our analysts buy stocks that they are recommending. We never let analysts buy a stock before they go to report." But that's just common sense.

Jenrette: That's not the problem. The problem is, pure research doesn't pay. What gets paid for is investment banking.

Donaldson: The problem is management of conflict. There are two sides to a trade. Who's your customer? The person who buys the security or the company that issues it? And that's why the guy in between needs to get paid a lot, for having the integrity to be able to manage that conflict and make the judgment to the satisfaction of both parties. But the pendulum has swung toward the issuers.

How did you feel when DLJ was sold to Credit Suisse?

Donaldson: Well, you're getting into a sensitive area.

Jenrette: We were all very sad about it. By the same token, we felt we were all three retired from it.

Lufkin: Absolutely!

Jenrette: And you can't run things from the grave or the beach or wherever. They did what they had to. One of the reasons they did was what I was talking about before, their need to be affiliated with a bank.

Donaldson: There was a great culture that persevered at DLJ through the years. And it existed up until the last day that it was DLJ. Perhaps the greatest asset of DLJ was the culture and the way of doing business.

Jenrette: It was the best place to work on Wall Street.

Donaldson: There were 40-plus years of investment in that. People loved to work there, and the company was eminently successful. Was there another way of handling [the DLJ acquisition]? Yes. Probably. Definitely. To say the least, I wish there had been some way to keep the DLJ name.