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The sunny side of the Street

Mainstream Wall Street research firms have had a tough year. But specialized boutiques have never done better.

Mainstream Wall Street research firms have had a tough year. But specialized boutiques have never done better.

By Jenny Anderson
December 2002

Midwest Research, a wholly owned subsidiary of Memphis-based First Tennessee Bank, is expanding its technology research effort in the jaws of a bear market. In the summer of 2000, just when the tech market was imploding, the firm hired a semiconductor analyst. Later that year it recruited a researcher to cover electronics manufacturing services, and in 2002 the firm brought in two analysts to cover hardware and software, respectively.

Who are these people -- and what are they thinking? Don't they know that adding unprofitable head count in the midst of one of the worst stock markets in memory -- let alone in the sector leading the nosedive -- is foolish?

For most firms that's gospel truth, but it turns out the hirings are pretty measured in light of Midwest's growth. Revenues at the six-year-old firm are up 96 percent this year from 2001. And last year's revenues gained 60 percent over the year before. With 18 analysts in all, the company -- hold your breath -- makes a profit on its research just from brokerage commissions.

"Our business is just exploding," says William Bischoff, Midwest's president and chief operating officer.

Many pint-size research firms and boutiques across the country offer similar stories. The grim market, intense regulatory scrutiny and angry investors may be slamming major Wall Street brokerage firms, hurting profits and forcing some analysts to seek other employment, but many of their less celebrated peers are doing quite well, thank you. Wall Street's loss is their gain: Revenues are up, firms are scrambling to expand, and they are touting their product -- sharply focused research -- as the antidote to the self-serving output of their bulge-bracket rivals.

"The credibility of sell-side research is shot," says Bischoff. "People are re-evaluating where to put their commissions."

Adds Jeffrey Leerink, co-founder of Boston-based Leerink Swann & Co., which specializes in health care: "We've really thrived in the past few years." In the past 12 months, his privately held research firm has opened a New York office, settled into new headquarters and doubled the size of its sales force and revenues. The expansion has kept profits flat, but that's okay, too. "There's a void, and we have been gaining market share," explains Leerink.

One reason these firms are thriving, say their portfolio management clients, is that they get paid for research ideas and not allocations to deals or corporate finance business. At least in the eyes of their customers, this arrangement puts a greater premium on quality and accuracy. "If you get things right five out of ten times in this business, you are a superstar," says one New York money manager. "Independent firms and boutiques get it right 50 percent of the time. The sell side gets it right one or two times out of ten."

As a result, this year's "Best of the Boutiques and Regionals" finds these smaller firms and independents at a sweet spot in their history. Leerink Swann wins the top award for Biotechnology, Medical Supplies & Devices and Pharmaceuticals/Major (knocking off last year's winner, SG Cowen). Although it has yet to reap the spoils of its technology buildup, Midwest grabs the No. 1 spot in three other categories: Machinery, Retailing/Department Stores & Broadlines and Retailing/Food & Drug Chains. In 2001 Midwest triumphed only in Machinery.

Debuting in II's poll, Portland, Oregon­based Pacific Crest Securities, a technology research firm, edges out SoundView Technology Group for the best applications software research. Fox-Pitt, Kelton wins in Brokers & Asset Managers -- a position held by Keefe, Bruyette & Woods in 2001. KBW, which suffered the devastating loss of 67 employees, including well-respected brokerage analyst Dean Eberling, in the September 11, 2001, terrorist attacks on the World Trade Center, still managed remarkable wins in large-cap and midcap banks as well as Mortgage Finance and Specialty Finance. Fox-Pitt was also rated best in Insurance/Life.

To be sure, a number of these firms share the same conflicts as their sell-side counterparts: KBW, for example, has an investment banking group, and about 2 percent of Leerink Swann's revenues come from deal making. Generally, though, most firms lack the capital and underwriting clout to do huge transactions. Many are built to be research companies. "We have designed our firm to be profitable on a research-only basis," says G. Alan Zimmermann, director of research at Fox-Pitt. "We think institutions have interest and will continue to pay commissions for research."

Buy-side clients say the regional and boutique firms are more diligent in research and analysis than their bulge-bracket colleagues. "They offer focus and they specialize," says Ted Truscott, chief investment officer at American Express Financial Advisors. "They tend to have proprietary insight."

In the spring of 2002, American Express brought in a group of high-profile money managers from Fidelity Investments and named Kevin Rogers, formerly a portfolio manager at Putnam Investments and Invesco, to the newly created position of director of independent research. His job: to seek out ideas and conduct proprietary research for the firm's portfolio managers. "In a Reg FD world where companies can't tell you anything, research needs to be independent, nonconsensus and proprietary," says Truscott, referring to the Securities and Exchange Commission's fair disclosure rule, which places tight strictures on communications between companies and analysts.

Boutiques vary greatly in size: Parsippany, New Jersey­based New Vernon Associates, for instance, has only six analysts, while KBW has 17 publishing analysts and 60 bankers. According to executives at independent firms and boutiques, salaries (in bull markets) are 50 to 70 percent lower for their analysts than for their peers on the Street. But thanks to regulatory reforms, that gap is closing fast as big firms fire analysts and reduce others' pay.

The downside: Boutiques lack a lot of what the buy side is looking for in terms of access to management. "Boutiques don't have the same resources as the sell side," says one asset manager who asked not to be named. "And they often don't talk to the company management. Some pride themselves on that, but quite frankly, it's part of the due diligence."

Certainly, boutiques have had a strong wind at their backs as of late. Not only are the major brokerages under attack for flawed research, but tough market conditions have prompted buy-siders to search more widely for ideas. Another aid: The burgeoning hedge fund business is relentless in trying to generate investment opportunities, for which it will pay full commission.

But do boutiques truly offer something different? Their principal distinction is that they usually specialize. KBW and Fox-Pitt concentrate on financial institutions, Pacific Crest focuses on technology, and Houston-based Howard Weil, which won in Integrated Oil, Natural Gas and Oil & Gas Exploration & Production, mainly sticks to energy. A defined focus often allows boutiques to push deeper into the industries they cover. "The problem isn't that sell-side research isn't independent," says Scott Sandbo, CEO of Pacific Crest. "The problem is that because the research was tailored to investment banking, it wasn't deep or focused research."

More important, though, say clients, these firms make their money by conducting in-depth, proprietary research. They don't have to contend with the time-consuming distractions of deal road shows or other marketing chores for investment bankers. And they rely on their own judgment. New Vernon, which wins top prize in Chemicals/Commodities for the second year in a row, focuses on chemicals research. Charles Neivert, an analyst there, tracks pricing in far greater depth than anyone on Wall Street, says a portfolio manager. "I've been working with him for four years, and he has never missed a commodity price trend," says this admirer. What are the analyst's competitors at large firms doing? "They hire consultants to draw their conclusions about pricing. Neivert draws his own conclusions, and he is right," says the manager.

Still, all would agree that making money on research is no easy task. Most get paid through trading when the buy side allocates commission dollars. "The sell side is not wrong in saying that at 5 cents or 6 cents per share, it's difficult to get paid," says onetime investment banker Leerink -- who built a firm almost entirely dependent on research revenues. But, he adds, "It's even harder to get paid when your research isn't good."

Smaller firms also tend to cover stocks that will generate a lot of trading activity for them, since they get paid from these commissions. "On the sell side you wind up with too many analysts who can't make money on a commission basis because they exist to bring in banking deals," says Fox-Pitt's Zimmermann. For research-driven firms the objectives -- finding interesting stocks that investors will buy and trade -- are different.

Independent research firms are wary of proposals floated by New York State Attorney General Eliot Spitzer and others to have major brokerages help fund the independents in return for access to their research. Why? Because it's unclear how the money will be distributed, how long it will last and whether the funds will undercut client relationships. Who gets access to the customer? "It is probably not nearly enough money," says Leerink. "And it depends on how it is spent."

No matter what, "this is a good time to be an independent research firm with a specialty," says Evan Morgan, vice chairman and director of institutional sales at Midwest. "The game is coming to us. When everyone was growing like mad in '98 and '99, we were growing more slowly. Now we are growing very quickly."

For our 2002 All-America Research Team, we asked investors to name the best boutique or regional firm by sector. Here are the outstanding firms (and honorable mentions) in their respective sectors.
Sector Best Firm Honorable Mention
Airfreight & Surface Transportation BB&T Capital Markets .
Airlines Raymond James & Associates .
Apparel, Footwear & Textiles Wells Fargo Securities .
Autos & Auto Parts McDonald Investments .
Banks/Large-Cap Keefe, Bruyette & Woods Fox-Pitt, Kelton
Banks/Midcap Keefe, Bruyette & Woods Fox-Pitt, Kelton
Biotechnology Leerink Swann & Co. .
Brokers & Asset Managers Fox-Pitt, Kelton Keefe, Bruyette & Woods, Putnam Lovell Securities
Business & Professional Services Robert W. Baird & Co. .
Chemicals/Commodity New Vernon Associates .
Economics International Strategy & Investment Group .
Electric Utilities A.G. Edwards & Sons Simmons & Co. International
Gaming & Lodging Hibernia Southcoast Capital .
Insurance/Life Fox-Pitt, Kelton .
Insurance/Nonlife Dowling & Partners Securities Fox-Pitt, Kelton, Keefe, Bruyette & Woods
Integrated Oil Machinery Howard Weil Midwest Research Simmons & Co. International
Medical Supplies & Devices Leerink Swann & Co. U.S. Bancorp Piper Jaffray
Mortgage Finance Keefe, Bruyette & Woods Friedman, Billings, Ramsey & Co. Research, Fox-Pitt, Kelton
Natural Gas Howard Weil Simmons & Co. International
Oil & Gas Exploration & Production Howard Weil Simmons & Co. International, Petrie Parkman & Co.
Oil Services & Equipment Simmons & Co. International Howard Weil, Johnson Rice & Co.
Paper & Forest Products D.A. Davidson & Co. .
Pharmaceuticals/Major Leerink Swann & Co. .
Radio & TV Broadcasting Wachovia Securities .
REITs Green Street Advisors .
Retailing/Department Stores & Broadlines Midwest Research A.G. Edwards & Sons
Retailing/Food & Drug Chains Midwest Research .
Retailing/Specialty Stores Buckingham Research Group Jefferies & Co.
Software/Applications Pacific Crest Securities .
Specialty Finance Keefe, Bruyette & Woods Fox-Pitt, Kelton