Independent research firms are in demand after reports suggested bias by analysts at some Wall Street's investment banking giants. Suzanne Miller in New York looks at a booming sector.
Some 20 years ago, when the late Sanford Bernstein still presided over his eponymous independent Wall Street research firm, he interviewed then-aspiring deal maker Ray Soifer. Now a market veteran with his own financial consultancy firm, Mr Soifer recalls his conversation with the legendary founder: "He asked me what I wanted to do and I said something Wall Street-related. Sanford shot back: 'Deals, deals, deals - everyone wants to do deals. Don't you want to make money?'"
Even today, the comment sounds outlandish, since research firms have never been billed as big money makers. It is a given that research firms at investment banks don't make money because they're cost centres set up principally to hawk other wares, such as investment banking products. But Mr Bernstein, who honed research as a cornerstone of his money management business, was "making money hand over fist" (as Mr Soifer recalls of those days) because he used top-flight research for discretionary account management: managing the money of the very rich and getting paid what Wall Street firms were pocketing for similar work.
Measuring success
These days, Sanford Bernstein is considered one of the most successful independent research firms in the US market. But how successful can a firm be if it has nothing to sell but research?
Last year Sanford Bernstein made $266m in revenue from research and another $400m-plus in revenue from managing money, according to analysts. While the firm also depends on money management and is one of the few independents to command such high revenue, the point remains: there's still money to be made from old-fashioned research.
"This is our moment in the sun," beams Richard Yamarone, director of economic research at Argus Research, a New York-based independent research group that supplies research to brokerage firms. His firm has had a roughly 25% increase in subscriptions over the past year, against a yearly average increase of 10% (the firm is private and doesn't disclose specific numbers).
"When compromised research hit the news, we started getting a lot of phone calls and started closing more deals," Mr Yamarone says. Argus works mostly with money managers, hedge funds and high net worth individuals. "We're an unblemished source - we have no reason to have a buy or sell in any direction," he adds.
This kind of testimony shows just how good life has become for the underdogs of the research world. Lisa Shalett, director of research at Sanford Bernstein, now owned by Alliance Capital, says: "Competition is definitely heating up among independent firms - it's energising for our franchise." She says over the past couple of years there has been "a burgeoning" of research start-ups that want to cash in on growing opportunities.
Some relatively recent new names include Fulcrum Global Partners, launched in May 2001 and staffed with several former Wall Street analysts, such as head of research Bob Hoehn, previously director of research at Dresdner Kleinwort Wasserstein. Vista Research, launched this June, hired managing director Stanton Green, a veteran Wall Street banker who has worked at firms such as Morgan Stanley and Merrill Lynch. CreditSights, launched in November 2000, employs former managing director at Deutsche Bank Glenn Reynolds as its head of global corporate sector strategy. These are just a few of the firms that have been bringing their financial research wares to the marketplace.
A growth sector
John Meserve, in charge of New York-based BNY Jaywalk - Bank of New York's recently acquired independent equity research consultancy - estimates there are now 250 independent research firms throughout the US. That number is probably even larger as many individuals are striking out on their own, preferring to avoid the public eye to preserve a greater sense of independence.
"There's probably at least 50 people off the radar screen. A lot of these guys left the Street and aren't interested in being known," Mr Meserve says. Those tired of working for traditional firms, or who were subjected to the Wall Street purge, are finding all sorts of jobs with investors such as hedge funds that are starting to outsource research. Mr Meserve says he knows of one analyst who recently started out on his own who has lined up 10 clients willing to pay some $250,000 a time.
Though hard numbers are nearly impossible to get because of limited disclosure, Mr Meserve estimates that 5% of total gross commission generated by buyside firms are used for research. "I expect that to go to 10% in the next few years because people are using more independents," he says.
Less of that money will be headed to Wall Street than in the past because of concerns over an indiscriminate number of buy recommendations. Chuck Hill, director of research at Thompson Financial/First Call, a firm that tracks analyst recommendations, says: "There has been horrendous distribution, where firms had an average 1%-2% of their recommendations as sells on stocks." More recently the average number of sells per firm has edged up to 3.7%.
That's still astoundingly low, considering the world economy has been bordering on recession. Morgan Stanley was one of the first to get "sell" religion when it cranked its sell recommendations on stocks to 22% from just 1%-2%. Even Prudential Securities, which got out of the banking business and is known for taking a contrarian view, still has a low number of sells - just 6%-7%, according to Mr Hill.
Despite these low numbers, analysts at mainstream firms are unlikely to raise their sell-to-buy ratio much more, for the simple reason that investors, despite protesting that they want the truth about their stocks, abhor bad news. "Remember that the vast number of stock ownership is owners of shares not short-sellers, so you don't win friends by issuing sells because you may just nick their stock," says Mark Roberts, who runs independent research firm Off Wall Street, which caters to hedge funds.
Off Wall Street specialises in sell recommendations but recently made a buy recommendation - the first in five years. "I like to throw curve balls," Mr Roberts jokes. His firm shot to fame during the Enron Senate hearings because it was one of the first to issue a "sell" on Enron, months before the energy giant went belly up. During Senate hearings, Wall Street bankers were grilled on how they were outsmarted by a small independent firm like Off Wall Street, staffed with some seven analysts, which issued the smoking 33-page Enron report.
Freedom to improve
Despite this, Mr Roberts resists criticising those who missed the boat. "Wall Street analysts are very smart people and it's not correct to think they're not doing the job they were hired to do." That job, he says, is to issue research and plenty of buy recommendations. "People should stop complaining about Wall Street and go somewhere else," he says of critics.
Independent firms are suited to fill the void left by traditional firms because they don't have to worry about investors who cry foul when a sell blows a hole in their stock, and there's nascent evidence that this freedom is helping them do a better job.
New York-based performance tracker Investars, launched in late 1999, says that on average, investors would have earned 4.9% return in 2001 by following the advice of independent researchers, compared with a loss of 11.5% if they listened to sellside firms. Investars tracks the recommendations of firms and then follows how the stocks perform, generating "portfolio" valuations.
"The Securities and Exchange Commission has been trying to place a value on research for a long time and it's been hard," says Investars chief executive Kei Kianpoor. In July 2001 he testified before Congress on the conflicts of interest in Wall Street research practices. "You get reports from 20 banks and delete them if you're a fund manager," says Mr Kianpoor.
He knows what he's talking about. Before co-launching Investars, he was a hedge fund manager and recalls when Priceline.com was worth more than all the airlines in the US combined: "It was the theatre of the absurd." He argued before Congress that the only way analysts will be held accountable for the calls they make is to rank their historic performance and let the results speak for themselves.