The 2004 All-America Research Team

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Having forced Wall Street firms to accept a historic $1.4 billion settlement with regulators over tainted securities research 18 months ago, New York State Attorney General Eliot Spitzer was able to move on to more prosaic matters, such as rooting out fraud in sales of mattresses online. But for Wall Street analysts and their clients, coming to terms with the post-Spitzer era remains a daily challenge.

Brokerage firm research departments have experienced unprecedented upheaval. Budgets have been slashed, paychecks chopped, analyst ranks pruned. Compliance officers have bivouacked en masse in research departments. Seasoned analysts have hastened their retirements or embarked on different careers. Several of those who have stayed on at their firms have transferred to more profitable departments, such as trading.

"It's a very difficult, very unsettling time," says Jonathan Boersma, vice president for standards of practice at the CFA Institute, the Charlottesville, Virginia-­based trade group that once called itself the Association for Investment Management and Research. "Everyone knows that the whole industry is in flux right now, and that doesn't help you sleep very well at night."

But out of the tumult a new look is emerging for Wall Street research: analysts who are younger, more vigorous and adaptable -- and more motivated by the nitty-gritty work of digging into companies than were some of the deal-fixated, fame-and-fortune-seeking analysts of the presettlement, stock-bubble days. Fresh faces abound. One of every nine analysts on Institutional Investor's 2004 All-America Research Team has never been ranked before; nearly one of every five winning analysts is new to the first team.

What's most striking, though, is that the best of the new guard -- the ones we feature on these pages -- continue to do superb work, according to the almost 3,500 portfolio managers and buy-side analysts, from nearly 700 institutions, who responded to the 33rd annual All-America team survey. And while many indicated frustration with the exodus of talented, experienced analysts, they also praised the newly emerging stock researchers for doing fine work. Indeed, our survey shows that All-America team voters are more satisfied now with the quality of research than they have been since 2000. Almost 70 percent of those responding to the supplemental survey sent with the All-America team questionnaire say that sell-side analysts today are more objective and accurate -- and less subject to conflicts -- than they were before the regulatory crackdown.

Tellingly, Lehman Brothers, a firm that has made a point of grooming young analysts, remains head and shoulders above its competitors, taking first place in the All-America rankings for a second consecutive year. Merrill Lynch, which likewise has poured resources into training recruits, rises from third place to second. A relative newcomer to the upper echelons of the U.S. research business, UBS, jumps two spots to third. By contrast, Morgan Stanley has four fewer team positions than last year and drops from second to fourth. Smith Barney Citigroup rounds out the top five, slipping from fourth last year (see leaders table above).

To be sure, Wall Street still has plenty of veteran analysts who are turning out first-rate work and being recognized for it. Among the more familiar faces in this year's lineup are: Goldman, Sachs & Co. biotechnology analyst Maykin Ho, who has been on the team for 11 straight years; Bear, Stearns & Co. accounting guru Patricia McConnell, who first appeared in 1990; Sanford C. Bernstein & Co. mortgage finance analyst Jonathan Gray, who debuted on the team in 1975; and International Strategy & Investment Group chairman and economics authority Ed Hyman, who was first ranked on the team in 1976 and has been the No. 1 economist for 25 straight years.

Yet it's easy to understand why so many longtime analysts would want to jump ship. For a start, there are the regulatory rigors of the Spitzer settlement and a battery of new Securities and Exchange Commission strictures intended to expunge even a hint of conflict of interest. Firms' internal committees now must approve ratings changes on stocks, and compliance chaperones monitor analysts' conversations with investment bankers and the press.

But the new regulatory regime is not all that's behind analyst flight. Factor in, too, the bursting of the Internet bubble followed by a three-year bear market. And don't dismiss dwindling compensation. With their paychecks no longer fattened indirectly by investment banking fees -- banking and research are now strictly quarantined -- analysts working for brokerage firms have seen their median pay fall from $230,000 in 2001 to $155,000 in 2003, according to the CFA Institute. Pay packages would have been thinner anyway because of the sharp recession in finance postbubble, but not like that.

What's more, alluring alternatives exist for well-established analysts, especially at hedge funds. Among the noteworthy departures this year: Morgan Stanley's Steven Galbraith, the top-ranked portfolio strategist in 2002 and 2003, who joined hedge-fund powerhouse Maverick Capital Management. Other veteran analysts are staying put but transferring their stock-picking skills to fresh areas, particularly proprietary trading, a major profit center today for big brokerages. Morgan Stanley's Anand Iyer, whose convertibles research team finished in first place in 2003, joined Andy Pipa, one of the firm's star traders, on a new proprietary convertible-arbitrage desk earlier this year. UBS's Samuel Buttrick, who has ranked first in the Airlines category for nine years running, is moving from that firm's research department to its prop-trading team.

Many analysts who have chosen to stick with the sell side find nonetheless that hedge funds are prompting changes in their jobs. These increasingly important and lucrative clients demand, for instance, recommendations on shorting stocks. Some firms more than others have aligned themselves with these frenetic traders. If you rank firms solely according to the 834 hedge fund voters who responded to the All-America team survey, casting a combined 16,700 votes, Goldman leaps to third place from eighth overall, while Morgan Stanley rises from fourth to second, switching places with Merrill.

Several firms, including independent research boutiques like Buckingham Research Group and Fulcrum Global Partners, have analysts who make the hedge-fund-only list but not the overall rankings. (Complete rankings of analysts by hedge fund investors will appear in the October/November issue of II sister publication Alpha; for more details, go to www.institutionalinvestor.com/alpha.)

The new order on Wall Street has caused more than a little carping by clients. Portfolio managers and buy-side analysts, who say in our surveys that they value sell-side analysts' knowledge of their industries above all, are upset at losing access to researchers with the kind of deep expertise that can be acquired only over many years. Many of the senior analysts who have left the field since 2000, when we first asked voters to assign scores to the quality of research, have been replaced by young, inexperienced associates -- if they've been replaced at all.

"The best people are leaving," grumbles one veteran portfolio manager. "Instead of talking to people who have spent ten or 20 years covering an industry, who know it like the back of their hand, know all the players, you're talking to some kid who's barely out of business school. That kid can't tell me anything I don't already know."

Still, as painful as the transition to the new generation of analysts may be for many such investors, clients don't automatically equate younger analysts with inferior work. Despite the high turnover in research ranks, institutional investors responding to our latest survey award today's analysts pretty high marks overall. Asked to rate sell-side research on a scale of 1 to 10, respondents gave the Street's efforts an average grade of 5.89 -- up from 5.67 for 2003 and a low of 5.55 for 2002. In fact, this year's figure was just a shade short of the 5.9 earned in 2000, when voting took place before the stock bubble had fully burst.

Some analysts say they feel more freedom to be negative on stocks. One example: Edward Wolfe, the first-place analyst in the Airfreight & Surface Transportation sector, earns praise from survey voters for slapping a sell rating on tank-truck operator Quality Distribution, an important client of his firm, Bear Stearns.

Voters single out as tops in their sectors 12 analysts who have never before achieved that distinction -- and more than a few who are fairly new to the business of research. Take James Covello, 31, who is barely four years out of Dartmouth College's Amos Tuck School of Business Administration. Covello became Goldman's lead analyst for semiconductor capital equipment shares just three years ago, and he first made the team in 2002 as a runner-up. The following year he moved up to second place, and this year ascends to No. 1.

Covello concedes that his youth has made it hard to gain the respect of investors. In his first major report, he predicted that spending on semiconductor capital equipment would decline again in 2002, after hitting what most thought was rock bottom the year before. His bold contrarian call turned out to be spot on, but "people dismissed it as, 'Well, he got lucky,'" recalls the analyst. "There was a lot of skepticism. I heard it in every marketing meeting, every call that we made."

Covello won over the skeptics the tried-and-true way on Wall Street: He consistently helped clients make fistfuls of money. This year he wins plaudits for another counterconsensus recommendation: downgrading his sector in February after judging that it had taken on the characteristics of a cyclical industry and therefore could not support current market valuations. Shortly thereafter, semiconductor capital equipment shares took a dive.

Jason Goldberg, who covers banks for Lehman, debuted as a first-teamer in the Banks/Midcap category in 2002, just a couple of years after joining Lehman from a junior position at Salomon Smith Barney. This year he wins that category for the third consecutive time -- making him a fairly seasoned analyst, at 31. (He also scores as a runner-up in Banks/Large-Cap.)

"Young or old, hard work goes a long way in this business," says Goldberg, a University of Michigan grad. "Clearly, if someone doesn't have a lot of experience, it may take time to build a reputation. But good, thought-out research gains credibility in the market very quickly."

Wall Street firms are realizing that they need to nurture their young talent. Goldman, for instance, has retained the services of highly regarded former chemicals analyst, Avi Nash, who left the firm in 2002 -- near the height of the controversy over equity research -- to form his own consulting outfit. Nash, who won All-America first-team honors seven times, spends two hours a week with a group of Goldman's junior analysts, tutoring them in financial modeling and stock picking in a program that lasts six months. Several other senior Goldman analysts also act as mentors.

First-teamer Covello says he got so much out of the sessions that he continues to attend them. "I spend a couple of hours a week with him talking about how to analyze cyclical stocks," says Covello, speaking of Nash. "At first people didn't think it made sense for a tech analyst to talk to a chemicals analyst. But I started to realize that a lot of the frameworks he applied to chemicals also applied very well to my stocks."

Five years ago, Lehman resurrected the hugely successful training program it rode to research dominance in the late 1980s and early '90s (Institutional Investor, October 2003). Merrill, whose reign atop the All-America rankings in the mid- to late 1990s resulted largely from its buying expensive outside talent, last year began a program similar to Lehman's to produce home-grown stars.

The very fact that top firms like Goldman, Merrill and Lehman are willing to invest seriously in training analysts underscores the abiding importance of quality research to clients. "We see that clients are starting to allocate more of their commissions for research than they have in the past," says Steven Hash, Lehman's global research chief. "All of the issues in the business have put a lot of pressure on research budgets, but I think most firms have cut too deep."

The great irony here is that the budget slashers -- if they were among the 12 firms now participating in the Spitzer deal (two, Thomas Weisel Partners and Deutsche Bank, settled late) -- must shell out hundreds of millions of dollars to subsidize independent research that they then must distribute to clients along with their own. The cost undoubtedly cuts into the budgets for in-house research at a number of brokerage firms.

For all 12 firms the settlement-stipulated independent research price tag totals $460 million over the next five years. Each of Spitzer's dozen must buy and make available to its clients at least one independent report for every stock the firm covers. And this freelance coverage must be kept current and delivered to customers in the same fashion as the firm's proprietary research. The overall costs range from $75 million apiece for Merrill, Citigroup and Morgan Stanley -- regulators deem these three to have been the worst offenders in research conflicts -- to $7.5 million and $2.5 million, respectively, for smaller brokerage firms Piper Jaffray and Weisel.

Plainly, independent research is about to move from the side lot into the main showroom. But as Wall Street is grudgingly coming to accept, independent research was already emerging from niche status. More and more money managers are seeking out stock reports that are guaranteed to be free of any taint of investment banking conflict -- because the producers of those reports, such as Fulcrum Global Partners and Precursor Group, don't happen to have investment banking arms. Demand for this type of unconflicted analysis was growing even before the research scandals of the 1990s, when some analysts at certain firms hyped dubious tech companies to ingratiate their firms with those companies' managers.

An overwhelming majority -- 76.5 percent -- of All-American voters who responded to the question now say they use independent research. Moreover, 46.6 percent say they plan to increase their budgets for such research, while only 1.5 percent expect to cut them.

Such investors are obvious beneficiaries of the Spitzer deal. But for the dozen Wall Street firms affected, providing a second opinion on every stock is turning out to be a monumental task -- the costs of which are sure to exceed the sums specified in the settlement. Each firm has had to hire a consultant to vet the performance of independent research shops and make sure their output is suitable for retail investors, a process that can take more than a year. Many consultants met with hundreds of research providers in the 15 months between the settlement date and the July 27 implementation deadline.

But the most expensive part of the whole process may be developing the infrastructure to receive and redistribute the independent reports. UBS contracted much of this task to a technology vendor, Wall Street On Demand, which aggregates reports from 34 independents and imports them into the same computer system that handles production and distribution of UBS's research. Any client calling up a UBS report on the firm's Web site finds that it is prominently tagged with a button the investor can click to receive an independent report on the same stock. Retail brokers at UBS must ask clients if they want to see independent research before processing their stock orders. And if the client replies, "Why not?," the brokers must deliver that research in whatever form the client normally receives research reports -- fax, mail, e-mail or online. Similar rituals take place at the other 11 firms.

"UBS has been extremely supportive of me during this whole process," says the firm's independent-research consultant, Michael Dritz, a former American Stock Exchange floor trader and ex-president of British brokerage Smith New Court, which was acquired in 1995 by Merrill. Dritz resigned as chairman of an independent film production company and turned down other consulting opportunities to work full-time on settlement-related business. "This involves a lot of time commitment and spending that's in addition to the cost of the research."

Will any of these changes accomplish Spitzer's ostensible objective -- aiding retail investors? Skeptics abound on that score. But there is one group that owes the state attorney general a hearty thanks (if not a generous future campaign contribution): producers of independent research. "This will help grow the independent research industry," says Dritz. "A lot of these small providers didn't have a way to market themselves before. Now they do."

And that just means even more pressure on researchers to dazzle clients the way the 334 analysts on our 2004 All-America Research Team do this year.

Click here to see the ranking.