Just short of a year after ten big securities firms agreed to pay fines and penalties of $1.4 billion and institute a raft of reforms to clean up tainted practices, the state of research on Wall Street remains remarkably unsettled.
The landmark legal settlement itself has not been approved by the federal courts overseeing its implementation. None of the firms has made any of the payments called for, and investors have yet to be able to read one syllable of the independent research that the pact requires investment banks -- at a cost of $432.5 million over five years -- to distribute to clients along with their own analyses.
But that doesn’t mean that the once-cozy world of Wall Street research -- with its now-too-familiar tales of conflict, misrepresentation and outright hucksterism -- hasn’t been upended. Quite the contrary. Changes have been coming rapidly as major firms race to revamp their equity research operations in anticipation of the settlement’s myriad nonfinancial provisions and in response to a host of other regulations promulgated over the past two years aimed at attacking conflicts of interest. Analysts at the ten settling firms are no longer accompanying bankers on pitches to corporate clients and cannot be compensated or evaluated on the basis of their contributions to banking, for instance. Any contact between researchers and their banking colleagues -- whether an in-person meeting, a phone call or an e-mail -- must be mediated by an in-house lawyer.
And though these changes are meant to be for the good -- and certainly to dispel any lingering high-handedness or corruption -- there is growing sentiment that the Street’s moves could, ironically, make the markets a riskier, less efficient and more dangerous place for the unsophisticated investors the settlement was supposed to protect.
No one’s even sure at this point exactly what the settlement looks like. Federal judge William Pauley III, who must approve the $1.4 billion deal, is still waiting for regulators and the firms to iron out niggling details like which investors are eligible to receive $387 million in restitution payments, whether the settlement’s provisions will apply to U.S. firms’ overseas operations and just how its $80 million in investor education funds will be accounted for once they are spent.
“I don’t see how the settlement is going to benefit the individual investor or the capital markets in general,” says Jack Rivkin, chief information officer at $65 billion-in-assets money manager Neuberger Berman. “The main effect I see it having so far is making the markets much less efficient. That’s good for professional investors, who do their own research, but it hurts individuals.”
The most obvious change in the landscape is the shrinking of research departments. This began with the downturn in business following the collapse of the 1990s stock bubble and accelerated after New York State Attorney General Eliot Spitzer pressed home his attack against illicit industry practices. Many of the Street’s most sober, seasoned and valuable analysts are fleeing the business, unhappy with the reams of new rules that have made their lives more bureaucratic, and disenchanted at having to work under a pervasive cloud of suspicion. A number have been fired, as securities firms slash budgets in an environment where investment banking fees can’t be used to pay analysts and research increasingly is viewed by senior management as a costly legal liability, not a brand-building asset. All too often the departed aren’t replaced. To help take up the slack, research directors are increasing the workloads of the typically younger, less experienced and less expensive analysts who remain. Worse, firms are simply dropping their coverage of hundreds of stocks.
All of these developments worry professional investors. “A lot of the analysts that I used to know are no longer on Wall Street,” says Richard Drake, a portfolio manager and co-head of research for ABN Amro’s U.S. investment management unit in Chicago. “It’s frustrating. I knew who I could go to for information before, and if that person’s not there anymore, I have to find someone new. It’s like my sources are disappearing and I have to go develop new ones. It makes it more difficult for me.”
Adds Rivkin: “The quality and the quantity of the research people are going to get, on balance, is going to go down. That, to me, is pretty clear.”
CHARLES PHILLIPS JR. LOVED HIS JOB. BUT HE had to leave it.
After graduating from the U.S. Air Force Academy and going on to earn an MBA and a law degree, Phillips went to Wall Street as a software analyst in 1986. By the mid-1990s he had become one of the most respected researchers in the business. Phillips was ranked the No. 1 enterprise software analyst for nine years running in this magazine’s annual survey of outstanding brokerage-firm researchers, admired as much for his squeaky-clean integrity as for his analytical acumen and deep industry knowledge. But in May, Phillips left Morgan Stanley and Wall Street to join a company he was well known for covering, enterprise software maker Oracle Corp., as head of strategic planning. People who know him say Phillips could no longer deal with the red tape and the constant suspicion of his motives that had become a daily reality in the past couple of years. “This just isn’t fun anymore,” he told close friends and colleagues.
Phillips’s move is emblematic of a broader disenchantment among seasoned analysts with how the postbubble regulatory backlash is changing the nature of their profession. Many other highly regarded analysts have decided to leave the sell-side research ranks in recent months. Among them are Alice Schroeder, twice a No. 1-ranked analyst in II’s insurance/nonlife category, who left Morgan Stanley to write a book with Warren Buffett; Judah Kraushaar, a runner-up in brokers and asset managers, who also was ranked for several years as the No. 1 large bank analyst, at Merrill Lynch & Co.; Christopher Shilakes, another Merrill star, who earned runner-up status in two software sectors last year; Merrill pharmaceuticals analyst Steven Tighe, a second teamer last year and top-ranked in his sector from 1999 to 2001, who left for hedge fund Exis Capital Management; Bear, Stearns & Co.'s No. 2-ranked gaming and lodging researcher Jason Ader, also a former first-teamer, who’s starting a hedge fund; and bank analyst Diane Glossman, a runner-up in the money center banks category from 1994 to 1999, who left UBS to train in hopes of making the U.S. Olympic equestrian team.
Analysts periodically leave the business, of course, and for any number of reasons. But the latest round of exits smacks more of a fundamental realignment than of normal attrition.
For all the pay and celebrity, analysts’ lives had become an ever more trying whirlwind by the late 1990s. The U.S. was crazy for stocks, and the demands made on researchers by investors, companies and their colleagues in the investment banking departments soared. Along with notoriety came other, less pleasant effects, including death threats from crazed retail investors and increased regulatory scrutiny (Institutional Investor, October 2000). But even average stock pickers were handsomely compensated, and, on balance, the job’s pros outweighed the cons.
Nowadays, analysts and research directors say, the job of researching companies, making rec- ommendations and communicating these ideas to investors has become far more difficult -- the result of grinding markets as well as new policies and procedures. Even so basic a task as initiating coverage on a company or changing a recommendation has become a complex process. In the past, an analyst would arrive at a conclusion, explain it to a research manager, clear it with a compliance officer, then deliver a report to investors. Now most firms have created “research recommendations committees” to handle these situations. Meetings of the committees -- which typically consist of representatives from research management, portfolio strategy, institutional sales, retail sales, compliance and sometimes fixed income -- can take a long time to schedule with so many people involved. The meetings also can drag on, because of heightened concerns among the committee members about analysts’ motives, as well as what many researchers interpret as accusatory and occasionally inane questioning.
“They insulted your intelligence,” complains one veteran analyst of his firm’s committee meetings. “There would be all these questions about, ‘Well, what happened in the third quarter of 1996, and how does that affect your conclusion?’ and, ‘Have you considered how the alignment of Jupiter and how the grass is growing in Tibet this year will impact your conclusion?’ Just off-the-wall stuff.”
Aside from the changes in business practices required by the settlement -- such as increased disclosure in research reports of conflicts, restrictions on analysts’ contact with investment bankers and involvement in transactions -- many firms are going further to limit future liability. Most big firms also are monitoring the e-mail and voice mail messages sent by their analysts, on the lookout for anything incriminating. It was e-mails from analysts deriding the stocks they had buys on, after all, that made Spitzer’s case. Merrill and Goldman, Sachs & Co. no longer allow analysts to use private e-mail accounts, like those offered by Yahoo! and Microsoft Corp., in the office.
Analysts’ private lives are affected further by the restrictions on interaction with investment banking personnel. Many have seen professional relationships with banking colleagues turn into close friendships over the years. Under today’s strains some of those ties are withering. (Technically, the settlement doesn’t prohibit social interaction, but analysts and bankers can’t discuss business outside the office without a compliance person present.)
“When I was an analyst, I was good friends with my bankers,” says one bulge-bracket research official. “There was nothing untoward about it. Our families would get together on the weekends. Now we don’t see each other. It is a little sad.”
Analysts also must confront a new, personal legal liability. Scores of arbitration claims and lawsuits brought by aggrieved investors name as defendants not only the companies that issued stocks and the brokerages that sold them but also the individual analysts who recommended the shares. The capper, of course, is that compensation for researchers, while still healthy by the average American’s standards, is a fraction of the dizzying levels reached during the boom years.
And that’s for the people who still have jobs. Dozens have been fired as their employers realign research departments for the post-Spitzer era. Citigroup’s newly restructured Smith Barney division laid off eight analysts in May -- including Michelle Applebaum, a highly ranked metals analyst, and Raymond Niles, whose coverage of utilities earned him praise from investors. Goldman also has slashed well-regarded researchers, including Martin Sankey, an electrical equipment analyst who now works for Neuberger, and Richard Strauss, a respected brokerage industry analyst who landed at Deutsche Bank.
In many cases, firms are leaving entire sectors uncovered as analysts depart or are fired. In other cases, research directors are asking experienced analysts who cover smaller sectors to abandon those stocks and shift to higher-profile names when a colleague leaves -- essentially filling one gap by creating another. Gibboney Huske, long a top-ranked imaging analyst at Credit Suisse First Boston, this year picked up coverage of enterprise software stocks like Microsoft and Oracle Corp. after the firm pushed George Gilbert aside. But in many other instances, green junior analysts are stepping into the voids left by these departures.
“I’m not interested in starting over with somebody who has no contacts and no industry knowledge,” an unhappy buy-sider says of the situation.
Maybe not, but starting from scratch is the stark reality facing many portfolio managers as Wall Street research directors fiddle with budgets and staffing. Indeed, the hot summer read among these bosses this year seems to have been former Salomon Brothers bond salesman Michael Lewis’s Moneyball. The book chronicles how Billy Beane, general manager of baseball’s Oakland Athletics, used a revolutionary statistical approach to evaluating talent that allowed him to put together a playoff contender on the major leagues’ lowest payroll. Research directors who are dealing with slashed budgets can relate.
“The Billy Beane model is not a bad way to be thinking about our business,” says James Clark, co-head of U.S. research at Credit Suisse First Boston. Adds Clark’s fellow co-head Diane Schumaker-Krieg, “We have identified a unique set of valuable analytical attributes, and our goal is to economically invest in analysts, internally and externally, who are long these attributes.”
At Merrill Lynch these days, a fundamental change is under way. From its very first days in the research business, the firm eagerly bought its way to prominence. In the early 1970s, when investment banks and brokerages figured out that the way to attract institutional brokerage dollars was to have a first-rate research department, thenMerrill chairman Donald Regan directed his underlings to throw unprecedented amounts of money at the top-ranked analysts. By 1976 Merrill was the industry’s dominant research firm, cultivating a star culture, and it never looked back. The settlement’s impact on Wall Street’s willingness to pay up for top performers -- as well as, to be fair, three years of down markets -- have changed all that.
In the new world of Moneyball, Merrill global research head Candace Browning talks about developing talent from within. Earlier this year Browning created a “research excellence” program for junior analysts, which consists of weekly training seminars on topics such as stock valuation and how to structure morning-call presentations. Also new is a program that assigns each junior analyst at the firm a senior analyst mentor who covers a different sector. Additionally, Merrill has created a monthly internal newsletter, “Research Exchange,” which is designed to build morale by featuring the department’s best stock picks of the past month and other analyst achievements.
“We’ve really concentrated on developing a bench internally,” says Browning, a former standout airline industry analyst. “We’ve never formally done much of that at Merrill before.” Lehman Brothers for the past several years has relied heavily on a similar training program to rebuild its research department, which reached elite status in the early 1990s before coming apart at the seams by the middle of that decade (see page 56).
Nearly every major research house is seeking to replace high-priced stars with cheaper, promising upstarts. Firms like J.P. Morgan and Morgan Stanley have even begun to outsource some of their number-crunching to outposts like Bombay, where skilled labor is far cheaper. Some firms are coming up with detailed mathematical formulas to evaluate analysts’ effectiveness and value and to assess the relative importance of individual sectors to the buy side. These efforts are aimed at uncovering and exploiting inefficiencies in the research labor market. One research manager, who insisted that he and his firm not be identified, said he was almost happy when a high-priced team of analysts jumped ship for a competitor recently. “We weren’t so upset when they left, because we thought they were grossly overpaid.”
Other firms are grappling with whether research can generate the kind of returns that justify major investments of time and money. Goldman, for example, has discussed internally and with large institutional clients the idea of dropping research altogether, say sources familiar with the matter. The obvious question is how much revenue the firm might lose while cutting the $250 million to $500 million per year it still costs to support a research department. For a firm like Goldman, with no retail system, the strongest investment banking relationships in the business and one of the most technologically advanced systems for efficiently processing institutional trades, gutting research might not mean sacrificing much revenue. And Goldman’s proprietary traders could probably earn a better return on the money that is being plowed into research. Securities firms with armies of retail brokers and weaker banking relationships may be less inclined to cast off their researchers. Goldman appears to be sticking with research, at least for now, but declines to discuss its plans.
ALTHOUGH IT’S TOO EARLY TO TELL IF ANY FIRMS will give up on research, one thing is clear -- most of them are dramatically scaling it back. In the past year Goldman has slashed the number of companies it covers by 23 percent. Merrill tracks just under 1,000 U.S. companies now, down about 25 percent from its bull market peak. Most other major firms have initiated similar cutbacks. For perspective, more than 6,200 companies are listed on the New York Stock Exchange and Nasdaq combined. The 5,000 or so stocks that aren’t covered by major Wall Street firms generally fall into the small- and midcap categories that investors often turn to when seeking to outperform the major indexes.
“We have an enormous franchise in the small- and midcap area, and dozens of analysts supporting it,” says Jeff Arricale, a researcher for T. Rowe Price Associates in Baltimore. “These are often undercovered stocks as it is. So if you have a lot of small- and midcap assets and you’re on the buy side, you better hope you have a big research department to pick up the slack.”
Firms like T. Rowe Price, Fidelity Investments, Capital Group and other huge institutions should be able to pick up the slack. But smaller institutions -- and individuals trying to pick their own stocks -- undoubtedly will suffer.
In sum, the information about publicly traded companies is shrinking, threatening to make the stock market less efficient. Individual clients of brokerage firms like Merrill and Smith Barney are losing the advice of veteran analysts about large companies and getting less insight on hundreds of potential gems in the mid- and small-cap world. The same fate awaits portfolio managers at mutual fund complexes, who control most of Main Street America’s stock market bets -- about $3.1 trillion, according to the Investment Company Institute.
The consequences aren’t limited to investors. Some experts caution that the cost of capital will rise for the young enterprises that often fuel economic growth. With less information available about these firms, investors will be more wary of owning their securities, thus making it more costly for them to raise capital to keep growing. Only 44 percent of Nasdaq’s 3,800 listed companies are followed by a sell-side analyst, according to Thomson Financial First Call. Additionally, some 90 stocks with market capitalizations of $1 billion or more are tracked by two or fewer analysts. “What you’re doing is raising the cost of capital for corporate America,” says Neuberger CIO Rivkin. “It’s going to cost them more to raise equity than it has historically -- particularly the smaller companies who will receive less attention from the Street.”
Even for bigger companies, the settlement’s strictures may slow down or make less efficient the machinery of the capital markets once underwriting and merger activity revives. The settlement may have strengthened walls between research and banking, but it leaves intact the model of integrated underwriting and brokerage services. When deal flow improves, Wall Street firms will still want their analysts -- who are usually the most knowledgeable people in the organization about the companies and sectors they cover -- to impart their expertise to banking colleagues and ensure that any transaction is executed properly. But the extensive intermediation required by the settlement is making this process significantly slower and more cumbersome.
“All the chaperoning is probably good for analysts in that it cuts down on the amount of times that banking will try to badger you, because they have to go through a lawyer now,” says one bulge-bracket research official, who declined to be identified. “But on the downside, it will definitely slow down the capital markets. When the interaction is needed between research and banking, no one knows what’s allowed and what’s not. If we were back to the level of activity you saw in 1999 or even in 2000, there would be so much sand in the wheels that the system would shut down.”
Some see publicly traded companies themselves filling the void by essentially taking up the role that analysts perform today. Companies traditionally have relied on Wall Street analysts as a sales force for their shares, argues Peter Ausnit, an independent consultant and former Deutsche Bank Securities technology analyst. But the technological advancements of the past decade make it possible for businesses to take the reams of information they generate about themselves and, with a minimum of effort, turn it into easily digestible content that investors can access on corporate Internet sites: Webcasts of management presentations, downloadable financial models, updated projections, press releases and the like. This approach could prove particularly attractive to companies that find themselves without coverage in the new era.
“What analysts add to the investment process is that they make it easy for the investor to understand a stock, but companies have all the tools and resources to run rings around analysts in that department if they so choose,” says Ausnit, who currently advises companies, such as Electronic Data Systems and TiVo, on how to market themselves directly to investors. “CFOs will become more like analysts, so to speak. You’ll see them putting out a press release, holding a conference call, putting out blast voice mails saying, ‘This is Bob Jones, CFO of Fortune 100 Inc. We just released our number. Here’s what it is, and call me or my IR guy if you have questions.’”
Ausnit says that some of his clients already are taking this approach. And other companies, such as Washington Mutual and Seagate Technology, have begun national advertising campaigns designed specifically to market their shares to investors. Still, it’s bound to be a long time before corporate America subsumes the role of Wall Street research, if it ever does.
In the meantime, there will be information gaps and market inefficiencies -- the kinds of disconnects that professional investors exploit to make money. Indeed, Wall Street research departments are rapidly organizing themselves to serve their best-paying customers: hedge funds, which trade frequently and thus generate the commission dollars that can sustain quality research in the post-Spitzer era. Although retail investors and mutual fund managers may get the same written reports, they may not necessarily receive the kind of personalized attention from analysts that help them draw nuanced conclusions. And in other cases, sell-side firms are creating new research products -- geared toward hedge funds -- that combine fundamental equity analysis with heavily quantitative research and advice about using derivatives strategies to boost equity returns. Main Street isn’t likely to benefit from this, either.
“What Spitzer doesn’t realize is that Wall Street doesn’t cater to the individual buying 100 shares at a time,” says ABN Amro’s Drake. “It caters to the hedge funds and the high-turnover funds. It doesn’t even cater to long-term-oriented institutions like us. We typically own a stock anywhere from three to five years. But the Street has to play to the paying customer, and the paying customer now is hedge funds and the hot money. We’re not trading enough to make anyone rich.”
