Independents' day

John Raitt, research director of Harris Associates, a $30 billion Chicago-based money management firm, was thinking about buying shares in a Powder River Basin, Wyoming, oil and gas company. But first, he wanted to investigate the quality of its reserves. So he did what many investment managers dream of doing: He found a geologist who had worked in the region, knew the reserves and had recently dined with the CEO. Raitt hired the geologist to scout out the area, study the exploration data, interview reservoir engineers, talk to senior management and write a ten-page report -- all in fewer than five days. Harris didn't invest in the company.

So how did Raitt find this geologist? He called Gerson Lehrman Group, a five-year-old independent investment research company that charges money managers for access to its database of 30,000 experts in the health care, energy, communications and technology industries.

"That geologist knew the area as well as anyone, and he was evenhanded. A sell-side analyst isn't going to do that," says Raitt.

Gerson Lehrman gave Harris Associates something that portfolio managers, mom-and-pop investors and regulators increasingly believe that mainstream Wall Street research operations cannot: deep, unbiased expertise from knowledgeable industry sources. "Investors told us that the most valuable insight they got for their investment idea was from an industry expert at a cocktail party," says Mark Gerson, 30. "We saw with great clarity that investors were misserved by Wall Street."

Nor is Gerson Lehrman alone. Independent research boutiques -- those that do not offer investment banking or any kind of consulting services to the industries or companies they cover -- are sprouting like summer weeds. Among them are Washington, D.C.­based Precursor Group, founded in June 2000 by two former Legg Mason analysts to focus on technology and telecommunications industry research; Fulcrum Global Partners, a New York­based institutional brokerage and research firm set up in May 2001 by former ING Barings Americas president and CEO Michael Petrycki; and New York­based Vista Research, started in June by Jack Hidary, founder of online tech recruiting site Dice (formerly EarthWeb).

These newcomers are among scores of independent boutiques trying to make their way peddling conflict-free securities research. They vary in style, expertise and product offerings. Some focus on equity, others on debt. There are both quantitative and qualitative firms. Boca Raton, Florida­based Avalon Group caters to hedge funds with a short-selling bias, while San Francisco­based OTA-Off the Record Research produces general market analysis in 80 industries. Some, like Fulcrum, have built trading desks; others, like Vista, direct trades through mainline brokers such as Merrill Lynch & Co. and Bear, Stearns & Co. Precursor does not do valuations or price targets for companies, homing in on industry catalysts instead; Fulcrum issues only buys and sells. Some are newly minted; others -- like New York­based Argus Research, which started offering independent research services to retail investors in 1934 -- have been around for years.

But the firms also have much in common. They tend to cover a small number of stocks, often in niches; most get paid through soft dollar relationships because they eschew underwriting; and many of their employees come from nontraditional walks of life: Analysts are just as likely to have a Ph.D. in Russian studies as an MBA.

Most significantly, though, many of these upstart firms are gaining exposure for their sometimes prescient calls -- calls they can make, say their fans, because they have the time to gather and analyze facts, and because, with no investment banking, they do not have to worry about offending clients or spending every waking hour marketing to clients or presenting at road shows.

"We're in the first ripple of a major tidal wave," says Michael Margolis, a former research analyst for Oppenheimer Capital and Thomson McKinnon Securities who founded Avalon in 1995 with David Hines, who previously ran an Arkansas-based short fund. "Think about it: Until you had Starbucks, you didn't know how good a cup of coffee could be. It's the same with research. You have an awareness that research can be and needs to be better. We're now in that stage."

Certainly their focused approach helps independents make iconoclastic calls. Avalon, for example, initiated coverage of ImClone Systems in April 2001 with a sell at a time when, according to First Call/Thomson Financial, every analyst on Wall Street had buys or strong buys on the stock. It has since dropped 82 percent and ImClone's former CEO and founder, Samuel Waksal, is under indictment for insider trading. In June 2001 Precursor founder and CEO Scott Cleland dubbed WorldCom a "dead model walking" and a "high-priced money pit." At the time, 74 percent of the Street had buys or strong buys on the stock; 22 percent had holds; just one analyst had a sell. Claudia Aebersold, then of Basler Kantonalbank in Switzerland, recommended selling WorldCom in December 2000.

Such performance is increasingly helping the independents take business from the big Wall Street firms that have dominated research since May Day 1975. That's when the elimination of fixed commissions turned research into a money-losing enterprise, hastening the demise of the many small firms and specialized houses that had been leaders in the institutional equities business.

Industry sources estimate that full-service investment banking and research giants on Wall Street now take in 95 percent of brokerage commissions. But with mainstream research under fire for its structural conflicts of interest and its reputation in tatters, independents estimate they can more than double their take in the next three to five years.

Investment firms like Deutsche Asset Management give reason for hope. A year ago management took a close look at the value it received for the $800 million it paid in global commission dollars. Independents received less than 5 percent of DAM's commission pool. "The value the independents helped us create was far greater than what we were paying them," concludes global head of trading Calvert Gunner Burkhart. "They're important to us." The result: Independents will receive close to 15 percent of DAM's commissions in the second half of 2002. And Burkhart is predicting that three to five years from now, independents could take 25 percent of the total dollars paid for research by all money managers.

"There was an unspoken but very real perception that money managers had to remain in the good graces of the major brokerage firms in return for capital, for IPO allocations, for access to First Call," Burkhart says. "That's changed. Today asset managers are looking to protect themselves and source out research and trading, because asset owners want to know what they are getting for their money."

Harris Associates' Raitt already dedicates 40 percent of his firm's $4.5 million to $5 million in annual commissions allocated for research to independent analysis. He says he'll gladly pay higher fees for quality independent work.

Opportunity extends far beyond traditional money managers. Hedge funds, a fast-growing source of trading dollars for Wall Street, are also big consumers of independent research. Jacob Doft, founder of $300 million hedge fund Highline Capital Management, says he spends between $1 million and $2 million per year on independent analysis, or about 25 percent of his total research budget. "It's up 100 percent a year for the past three years, and it will continue to rise," he says. Gerson Lehrman pulled in $10 million in revenues in 2001, with $1 million in profits. It expects to more than double those profits this year. Its clients range from Merrill Lynch Investment Managers to hedge funds like Morgens, Waterfall, Vintiadis & Co. and Blue Ridge Capital, an early investor in the firm.

To be sure, independent research firms face plenty of obstacles. Most are still tiny, covering ten to 20 stocks compared with the 500 or 1,000 that a sell-side firm might cover. "It has been a cottage industry at best, with [firms run by] a guy who left the sell side because he wanted to live on his houseboat in Washington," says John Meserve, president of New York­based BNY-Jaywalk, which was founded in 1999 to aggregate independent research. Jaywalk distributes reports from 32 firms on 5,500 stocks and is now owned by Bank of New York Co.

There are other hurdles: The firms that have set up trading desks cannot offer the execution efficiency of the ECNs and full-service competitors. And attracting and retaining talent remains a major challenge. While independent shops boast that they will not pay the multimillion-dollar salaries once common on the Street, "talent goes where money grows" is a basic precept of a market economy. Daniel Peris -- an analyst at Argus who downgraded AOL Time Warner when the stock was around $50 in November 2000 (it recently traded at $12) -- recently moved to Federated Investors. The reason: He thought it was safer to be on the buy side in down markets.

Can independent research firms maintain their hot streak? Many are doing well right now in part because the market is doing badly, and they tend to focus on negative analysis. Avalon's call distribution is 70 percent sell to 30 percent buy; Fulcrum ranges from about 40 percent to 50 percent sells. A critical test of their staying power will come when the market is strong and investors want to buy. "Independent research doesn't guarantee quality," says Precursor's Cleland. "It just makes it possible."

Ironically, many hedge funds hope that independent research groups won't grow too big. They don't want to see the ideas widely disseminated. "There are hundreds of hedge funds that are getting the same independent research," grouses Highline Capital's Doft. "If you don't get it, you know less. If you do get it, you don't necessarily know any more." His preference? Proprietary research or firms that cater to no more than ten clients. Such sentiments will make it harder for independent research to grow.

For the time being, Wall Street itself does not appear to be overly concerned about the competition. Says the research director at a bulge-bracket firm: "I'm not about to lose any sleep at night over whether any of these firms is going to put us out of business." Of course, he and his peers have plenty of other reasons to lose sleep. The anger toward the sell side is palpable these days. Increasingly typical is the observation by State Street Research and Management's Larry Haverty, who oversees $900 million of his firm's $45 billion portfolio. "Analysts don't eat by making me money -- it's the last thing they care about," he says.

WALL STREET RESEARCH WASN'T ALWAYS TAINTED, and research independent of investment banking is hardly new. Four decades ago firms like Donaldson, Lufkin & Jenrette got their start focusing on pure analysis, for which they were compensated with trading commissions. Since it made little sense to research bad companies, they later began to make recommendations. Sanford C. Bernstein & Co. still operates without investment banking today.

"In the old days you spent most of your time doing research," says Dennis Leibowitz, a former All-America Research Team analyst from DLJ who now runs a hedge fund. "You didn't spend half your time on comments that they were off a penny and previewing the next quarter and all of that. It was much more intellectually challenging and interesting."

When the Securities and Exchange Commission ended fixed trading commissions and opened them up to competition in May 1975, trading profits plunged. Investment banks began to subsidize research with revenues from their lucrative business of underwriting. "We didn't want to do underwriting," says James Balog, a retired William D. Witter analyst. "Then May Day came, and that was the end of research."

Research as it was once known, at least. Today the global research budgets at major brokerages range from $500 million to $1 billion. It was the need to pay for all those salaries and overhead that put Wall Street's independent judgment in the spotlight. Retail customers shop for discounts, and buy-side firms want cut-rate commissions for the research, execution and capital, as well as the services like Bloomberg terminals, that they get. So investment banking picks up the lion's share of the costs.

This model looks sure to change. In late September Citigroup/Salomon Smith Barney reportedly discussed a plan with the National Association of Securities Dealers and the SEC to separate research from investment banking and, possibly, fund it like corporate overhead. When New York State Attorney General Eliot Spitzer argued for separating research from investment banking this Spring, he was rebuffed. Now, he says, the industry is coming to him with similar solutions. "I'm not ready to say it's the only way, but the facts are eminently clear that with investment banking and research existing under the same roof, the conflicts are hard to mediate," Spitzer asserts. "There is a willingness by people in the industry to consider alternatives because of what has happened. There's a certain impact to four successive months of headlines detailing conflicts of interest and abuses in the banks."

The raft of new regulations -- and the fact that 2002 earnings are expected to be half those of 2000, albeit a record year -- paints a gloomy picture for firms whose research is paid for with banking dollars. "There will be less money for research, which will lead to less research on Wall Street," says John Eade, president of Argus Research. "There is not any less demand, and independent researchers will fill that void."

INDEPENDENT RESEARCH HAS MANY FACES. THE best known and most respected is that of Sanford C. Bernstein, now part of Alliance Capital Management. Trading and asset management, not investment banking, pay for the firm's research, which is considered by some to be the most thorough on the Street. Its analysts -- who, more often than not, come from industry -- are valued for their depth of knowledge and their lack of conflicts of interest. "I'll always pick up a Bernstein black book before looking at Wall Street's research," says Kevin McCloskey, a portfolio manager at Federated Investors. "The Street only gives you one side of the picture -- the positive side."

Some major firms are styling themselves as independents. Prudential exited the investment banking business in December 2000. In May, in a dramatic shift of strategy, Charles Schwab & Co. announced that it would rate 3,500 stocks, based on a computer model that tries to predict how stocks will perform over the next 12 months. Schwab previously offered third-party research, including research from Argus, Goldman, Sachs & Co. and First Call. This month E*Trade Group launched institutional research with six analysts hired from Crédit Lyonnais.

Many of the boutique firms are growing quickly: Avalon has doubled its minimum fee every year since it started. "The law enforcement model says you go to those on the ground and talk to those who are suppliers and vendors," says Hines. "The last person we talk to is the suspect. That's the company." Avalon covers 50 stocks today, compared with a dozen two years ago. It picks stocks where it disagrees with the consensus, and it tries to prove the contrarian case.

Fulcrum has 17 analysts, a sales force of 25 and says it has $50 million in annual revenues. Founder Petrycki says the firm has been profitable for the past four months. Petrycki, whose firm has its own trading arm, argues that trading allows firms to capture the real profits. "If you don't trade, your real margin goes away," he says.

Opportunity, some independents argue, comes from not wasting a lot of time on replicating the work of the buy side on valuations and price targets. Some groups don't even pick stocks. Craig Gordon, who founded OTA-Off the Record in 1994 after 11 years as director of grassroots research for Rosenberg Capital Management, delivers pure market research to his clients. OTA-Off the Record has 60 to 80 customers, including Stanley Druckenmiller at Duquesne Capital Management, Stephen Mandel at Lone Pine Capital and Ronald Ogner of Strong Capital Management, most of whom use 15 to 20 percent of their budgets for independent research. The firm's secret approach: Time series analysis based on talking to "customers, competitors, suppliers and industry experts" and data culled from companies' U.S. and international operations. "The best and the brightest develop their own information or subcontract it out," says Gordon of the buy side.

Precursor picks stocks but focuses on major industry changes. Its 14 analysts report them to clients in concise, well-crafted one-page research summaries. Last year the firm inveighed against competitive local exchange carriers, or CLECs, and the telecom industry in general; this year it bet against cable. Both calls proved correct. This month Precursor reversed its telecom call and upgraded the sector from underweight to market weight. "For the first time we see a light at the end of the tunnel," says CEO Cleland.

Cleland has become the de facto spokesperson for the independent research community. He has testified before Congress seven times on issues ranging from the telecom industry to sell-side conflicts of interest. He thinks that new regulations will do little to change the embedded conflicts of interest. "The problem is not disclosure," says Cleland. "The problem is representing banking-influenced research as independent and objective." His solution? Instead of bundling research, trading and banking, unbundle the fees and show investors what they are paying for.

At the other end of the research spectrum of independent research firms are companies like Kroll Worldwide, famous for its security work and business investigations. Kroll's private investigators are now working to help hedge funds flesh out research ideas.

Kroll got into the business in late 2000 while checking out hedge fund managers for investors. Now it investigates potential investments for some funds. Kroll charges $100,000 to $500,000 per project -- generally, they last one to two months -- or hourly rates of $150 to $300. Kroll has worked with ten clients in the past 12 months and it expects to triple that next year, says Charles Carr, who will shortly head the hedge fund group.

The work Kroll does can save investment managers millions. One West Coast fund -- Kroll won't disclose client names -- asked Kroll to investigate ACLN, a Cyprus-based shipping company trading on the New York Stock Exchange. The company claimed $50 million in revenues from shipping new cars to Africa. Kroll examined the records at three West African ports and determined that the company had no new car business and that its used car business was shipping far fewer cars than stated in its earnings. The SEC halted trading in ACLN stock in mid-March, citing information provided to the commission that raised "concerns as to the adequacy and accuracy of the company's publicly disseminated information."

For now, the Precursors and Avalons of the world will only put a small dent in Wall Street's business. But as the Street continues to be sullied by stories of mismanagement and malfeasance, independent firms have an opportunity to flourish in a way they haven't since the heyday of research in the 1960s, when boutiques held sway before the consolidation of financial firms.

Whether this happens, of course, is up to the big institutional investors. "If they put 15 percent of their commission dollars into independent research, you'd end up with a handful of powerful firms that will be able to make them more money," says Avalon's Margolis. "It's like an election. If you don't like what you have, vote them out. All the buy side has to do is change."

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