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“If a boutique research house or a regional brokerage gives me better service than a big Wall Street firm, they’ll get the commissions,” vows a portfolio manager at a small investment firm who believes big brokerage firms cater increasingly to only their largest or more active clients.
In a scenario out of A Star Is Born, investment boutiques, regional brokers and a raft of freshly minted independent research outfits have seized the opportunity presented by big investment banks’ regulatory travails to demonstrate that their own analysts’ work is the equal of -- and, in some cases, even better than -- that of hotshot Wall Street analysts.
Consider the efforts of Richard Prentiss Jr., a telecommunications analyst at St. Petersburg, Floridabased regional brokerage and investment bank Raymond James & Associates. In the depths of the bear market, Prentiss maintained coverage of the wireless tower industry, unlike most of his sell-side peers, even though the business’s biggest players and its market capitalization had all but disappeared. In November 2002 he stuck his neck out and recommended small-cap American Tower Corp. at 3.15. Two years later the shares had jumped nearly sixfold, to 18.20, underscoring the opinion of one buy-side research director, who says that the smaller research houses “do better investigative work” than the biggest.
To be sure, the good reviews of many of the smaller firms, and particularly those of the independents, would not have been nearly as possible without Wall Street’s misfortunes. To settle conflict-of-interest charges with New York State Attorney General Eliot Spitzer and other regulators, 12 major institutions -- including research heavyweights Citigroup, Merrill Lynch and Morgan Stanley -- agreed to ring-fence their research departments from their investment banking operations to prevent analysts from pitching deals and tainting their research. As a font of hundreds of millions of dollars in subsidies from investment bankers dried up over the past two years, sell-side research bosses have slashed head counts, jettisoned unprofitable services and dropped coverage of some areas, such as small-cap stocks, while learning to subsist on brokerage commissions alone. Merrill Lynch, which in 2000 boasted a 650-strong research roster tracking 3,000 stocks, today has 485 analysts monitoring 2,500 stocks.
The $1.4 billion global research settlement requires the 12 firms to make research from independents -- those with no investment banking operations whatsoever -- available to their retail customers to provide them with, in effect, a second opinion. The firms are obligated to pay out $460 million over the next five years to support the independents.
Thanks in good measure to the first sprinkling of the settlement money -- which began to reach independents in July -- this has been a banner year all-around for research at smaller firms. Many firms are adding to their analyst ranks and expanding their coverage lists to take on Wall Street. Regional brokerage, boutique and independent analysts are coming up with surprisingly good stock picks that often defy conventional wisdom as they seek to stand out in this increasingly wide-open research marketplace. And they’re being better compensated for their trouble. What’s more, the beneficiaries include not only the obvious -- independents -- but also regionals and boutiques that do some banking. Their analysts are also branching out into areas once ceded to the biggest firms.
“The greatest thing Eliot Spitzer has done for us is to create more accountability for the allocation of commissions,” says Eric Bosshard, research director at Cleveland’s FTN Midwest Research, a leading boutique. Under the old system, he explains, “we might have been ranked 15th in providing high-quality research, but we were paid like we were the 40th best,” because institutional investors had considerations in mind when they doled out trading commissions other than just the quality of research (such as getting in on IPO allocations). Bosshard won’t divulge FTN Midwest’s commissions beyond saying that he believes that today they more accurately reflect the value of his firm’s research.
Which firms do investors think are doing the most outstanding work? As part of the surveying process for our annual All-America Research Team, we asked that question of analysts and portfolio managers at investment firms; some 1,400 at about 440 firms responded to help us name our 2004 best of the boutiques and regionals. And this year we also asked respondents to identify separately the top strictly independent firms -- those without any investment banking ties.
For the boutiques and regionals, we received enough votes to publish results in 42 investment categories (compared with 71 in the 2004 All-America Research Team). In each a winning firm was selected; honorable mention was awarded to those that exceeded a minimum vote threshold.
FTN Midwest takes top honors in five of these categories: Food, Machinery, Retailing/Broadlines & Department Stores (broadlines include discounters such as Wal-Mart Stores), Retailing/Food & Drug Chains and Retailing/Hardlines (“big box” retailers such as Circuit City Stores and Home Depot).
Three firms lead in four sectors apiece. Fulcrum Global Partners, a New Yorkbased boutique research house, impresses investors with its coverage of the Cable & Satellite, Chemicals/Commodity, Entertainment and Gaming & Lodging industries. Also in New York, Keefe, Bruyette & Woods, an investment banking boutique that tracks the financial services industry, wins in the Banks/Large-Cap, Banks/Midcap, Brokers & Asset Managers and Specialty Finance sectors. Leerink Swann & Co., a Boston-based health care research boutique with a small investment banking business, is judged best in Biotechnology, Medical Supplies & Devices, Pharmaceuticals/Major and Pharmaceuticals/Specialty.
All of these, and other, smaller firms have been eager to fill the research void left by Wall Street’s partial retreat. Milwaukee’s Robert W. Baird & Co., a full-service regional brokerage that tops our Business & Professional Services category, has expanded its coverage list by 10 percent each year since 2000 and will do so again in 2005, says research head Robert Venable. The firm musters 30 teams led by senior analysts (80 researchers in total) that follow 430 stocks in nine sectors, 80 percent of them in the small- and midcap markets.
All see a chance to shine. “Research is the most differentiated product on Wall Street,” contends Fulcrum research director Robert Hoehn Jr. Analysts can distinguish themselves and add value for clients, he suggests, by using unique sources and methods to reach distinct conclusions about stocks.
Analysts everywhere are being pushed as never before to put a one-of-a-kind stamp on their recommendations. Early this year, FTN Midwest analyst Brian Rayle devoted his monthly survey of heavy-duty-truck dealers to getting their reactions to diesel-maker Cummins’s new emissions-compliant engine and asking whether they thought it would take away market share from archrival Caterpillar. The dealers were enthusiastic about the engine -- unlike most stock market investors. On March 2, Rayle upgraded Cummins from hold to buy, at 51.37; through mid-November, as Cummins picked up market share, its stock rose by 50 percent, to 76.95.
Rayle’s work epitomizes shrewd research. Strictly speaking, however, FTN Midwest isn’t independent: It has a small affiliate that does a bit of dealmaking and in late September acquired a New Yorkbased banking boutique, Alterity Partners.
Many boutiques and regionals respected for the quality of their equity research, including Baird, Fox-Pitt, Kelton, KBW and Leerink Swann, employ at least a few investment bankers -- and in some cases, scores of them. These firms, and hundreds of their counterparts, make up an increasingly diverse business.
Research firms today come in all shapes and sizes and utilize all sorts of business models. Some only offer research; others are tied to brokerage operations; still others have a loose relationship with their parent companies’ investment banking units. And there are lots of variations to even this sometimes confusing mix: Some firms consider themselves expert in equity research, which they apply to many different industries; others are part of diversified investment banking firms that offer multiple services to a single industry. One recent creation is the aggregator: These firms gather and distribute research from many small firms and then act as the stockbroker for them when their work generates commissions from investors.
To identify those wholly independent research firms that investors most admire, II asked buy-side respondents to our All-America Research Team survey to name the sources of independent U.S. equity research that they had found most valuable over the preceding 12 months. They were asked to cite up to four firms in each of ten supersectors. (We used broader categories here because independent research is so highly fragmented.) Based on score the researchers were ranked first, second or third. All firms that topped a minimum vote threshold were given an honorable mention.
Our independents ranking drew in some rather large, research-focused entities, notably New Yorkbased Sanford C. Bernstein & Co. and Prudential Equity Group; they eschew corporate finance; they are too big to qualify for the best of the boutiques and regionals ranking. Each of these firms placed more than a dozen analysts on II’s 2004 All-America Research Team. Two much smaller firms, Washington, D.C.based economics and government policy specialists International Strategy & Investment Group and New York investment strategy experts Empirical Research Partners, also make both the All-America team and independents rankings, suggesting that investors appreciate solid, unbiased work regardless of the size or business plan of the source.
The much-admired Sanford C. Bernstein, whose research department is tiny by the standard of major Wall Street firms, wins in five of the ten supersectors: Capital Goods/Industrials, Consumer, Energy, Financial Institutions and Technology -- and ranks in four others. In Macro, the one area where Sanford C. Bernstein doesn’t achieve a ranking, it does at least have some claim on a winner. Empirical Research, which takes second place in Macro, is run by Sanford C. Bernstein’s former strategist Michael Goldstein. Prudential places in eight categories.
As strong a showing as these well-known research providers make, several other smaller firms -- including Fulcrum, New Yorkbased Gerson Lehrman Group, New Vernon Associates in Parsippany, New Jersey, and Washington, D.C.based Precursor Group -- manage to elbow aside bigger shops to walk off with the top spots in Media, Health Care, Basic Materials and Telecommunications, respectively.
Some overlap is unavoidable between our rankings of independents and the best of the boutiques and regionals. In all, seven research providers, New Vernon, Buckingham Research Group, Fulcrum, Portales Partners, Green Street Advisors, ISI Group and Empirical met the criteria for both rankings. ISI Group and Empirical qualified for all three of II’s U.S. equity rankings: All-America, the best of the boutiques and regionals and the best independents.
For the independents this is a hugely promising but challenging time. This summer, Fulcrum became one of more than a dozen independents that began offering research through Wall Street firms that are party to the global research settlement, when it was chosen by Morgan Stanley as one of its settlement providers. This relatively small group of firms includes Fulcrum and broader-gauge operators like Standard & Poor’s. The research aggregators like Bank of New York Co. subsidiary BNY Jaywalk and Soleil Securities Corp. are also playing a key intermediary role for some of the settlement brokers and independent research firms. Dozens of small research providers distribute their research through these aggregators.
As one of Morgan Stanley’s eight independent research firms, Fulcrum makes its work available to the brokerage’s retail clients (technically, an institution could choose to request it as well) by mail or e-mail or through Morgan Stanley’s Web site. Morgan Stanley pays Fulcrum an undisclosed fee on each stock for which the brokerage firm deems Fulcrum to be its designated independent research provider -- in essence its No. 1 backup (to its own work) on that stock.
Of the 188 stocks on which Fulcrum had a chance to be named designated provider, says Fulcrum research chief Hoehn, his firm got the designation on 101. “That,” he notes, “is a pretty good hit ratio.”
For all the hoopla, Hoehn and his counterparts at other independent research firms don’t view their new relationship with the major Wall Street firms as a huge financial opportunity. Indeed, many independent research firms with a significant institutional clientele have been loath to participate. Precursor Group, which specializes in telecom research, decided that distributing its work more widely -- especially to retail customers -- would dilute the research’s appeal to sophisticated institutional investors. That, in Precursor’s view, was a more important consideration than getting a sliver of the $460 million settlement payout.
For Fulcrum, the revenue is not “significant,” concedes Hoehn, who estimates that it won’t reach 5 percent of the firm’s revenues anytime soon. Most of Fulcrum’s revenues come from trading commissions. But he points out that the Morgan Stanley arrangement “is additive to the firm without diluting our basic business.”
For independents the Wall Street connection is far richer in exposure that could someday bring more business than in dollars in hand. Andrew Cursio, who manages retail equity research products for S&P, says that since late July, when five of the brokerages began putting up S&P research, twice as many investors -- some 40 million -- have had access to certain S&P stock research.
When all is written and distributed, the truth is that big Wall Street firms still dominate stock research. Even after all its cutbacks, Merrill still covers more than six times as many stocks as a big successful regional like Raymond James. With their global reach the giant firms remain uniquely situated to provide that commanding big-picture view of international business and economic trends. Bulge-bracket investment banks simply have greater breadth.
“If I want a look at 2005 earnings, I can call a couple of bulge-bracket analysts and ask for their estimates on all their companies,” says one highly regarded buy-side analyst. “But boutiques are more specialized and can’t offer me the broader picture.”
Nevertheless, the smaller research firms believe -- not without justification -- that they can make the most of this once-in-a-generation opportunity and create profitable niches for themselves if they keep a lid on costs, offer provocative research and pick their spots.
“We don’t have unlimited resources or the budgets that the New York firms do, so we have to execute well and stay focused,” says Baird’s Venable. “We like where we sit.”
Our rankings of the best boutiques, regionals and independents were compiled by IIEditorial Research staff under the direction of Director of Research Operations Group Sathya Rajavelu, Assistant Managing Editor for Research Lewis Knox and Senior Editor Jane B. Kenney, with Associate Editors Daniel Gaviria and Sivert Hagen and Researchers Opoku Danquah and Carolina Santos.
