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12/20/2010

The New You: The Future of Securities Analysis


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The Future of Securities Analysis Embattled as the financial services industry is at present, there's nevertheless a sense that the light of day has broken on transactions and markets too long shrouded in shadow. Corporations and executives are snatching eagerly at the opportunity to reinvent and revivify—and absolve—the profession.

But what will that makeover mean for practitioners? What will securities analysis look like 10–15 years down the road? Will the profession expand or contract? Will the majority of jobs be in the US or abroad?

What opportunities and challenges will securities analysts face, whether they are employed on the buy side, the sell side, or by independent research firms? How will their jobs change to meet tomorrow’s demands? What must-have skills will analysts be expected to possess?

Here to answer these questions—and to posit others—are five veterans of the industry, drawn from diverse specializations.  

Candace Browning is the head of Banc of America Securities–Merrill Lynch Global Research in New York. She joined Merrill Lynch in 1990 as a research analyst covering the US airline industry before moving up the ranks, eventually becoming head of Merrill Lynch Global Research in 2003.

Bob Johnson, PhD, CFA, is the deputy CEO and managing director of CFA Institute’s education division in Charlottesville, Virginia, where he manages the group’s professional ethics initiatives and is in charge of administration and development for both the CFA (Chartered Financial Analyst) and CIPM (Certificate in Investment Performance Measurement) programs. He joined CFA Institute in 1996 as vice president for the CFA program curriculum. Previously, Johnson had served as professor of finance at Creighton University and as president of JBK Capital Management.

Mike Kastner, CFA, is the chief market strategist at Sterling Stamos Capital Management in New York, and was previously the firm’s managing director of fixed income and the head of risk management. Prior to this, he served for seven years with Deutsche Bank in New York as the head of taxable fixed-income portfolio management.

Rich Leggett is the chairman and CEO of Business Intelligence Advisors of Boston and Herndon, Virginia, and the chairman of Investorside Research, an association for independent research firms. Formerly, he ran the governance business unit at RiskMetrics Group. He was CEO and, later, president of the Center for Financial Research and Analysis, which RiskMetrics acquired in 2007.

Stephen T. McClellan, CFA, worked for 32 years as a Wall Street analyst covering high-tech stocks. Now in San Francisco, he is the author of Full of BullDo What Wall Street Does, Not What It Says, to Make Money in the Market. He was a first vice president at Merrill Lynch for 18 years, after serving as a vice president at Salomon Brothers for 8 years.

RIGHT HERE, RIGHT NOW

BROWNING:

I think to answer the question of where the profession of securities analysis is going, you have to take a step back and first look at why Wall Street banks do what they do, what value that brings, and why they spend time and money on research. 

To me, banks are a major force in allocating capital to companies and industries with the strongest profit outlooks. These are judgment calls. That means that sell-side research is going to exist within the largest of banks; those large banks need this function. It is a very resilient profession. Will it change? Yes, it will. But the basic functions and value that sell-side research provides to all audiences, I don’t see that changing.

MCCLELLAN:

I believe sell-side research really started to decline with the Internet bubble. Now research is a mile wide but only an inch deep. There’s lots of marketing and client contact taking place but the emphasis is on quantity over quality, speed over thoughtfulness. Part of that is due to research budgets that have shrunk and senior analysts who have retired or gone over to hedge funds.

This has to change. The ratio of 80% marketing of services and 20% research will have to flip-flop. All of the previous sell-side Institutional Investor team rankings and Tv hype appearances by analysts will fade. There won’t be any popularity polls. Analysts will go back to being like CPAs and doctors.

LEGGETT:

The Global Research Analyst Settlement of 2003–2004 has had an impact. I think the quality of research on the sell side has declined. 

During the settlement I worked at Goldman Sachs on the research side, then went to the investment banking side. The settlement was rooted in the right idea but not executed well. It was supposed to create a more vibrant research environment. 

But what used to be a positive experience of building banking together with research has gone away. Now the job isn’t as interesting anymore, which has led to talent loss, reduced budgets, and poor research coverage. 

However, the settlement (and the requirement for additional, third-party research to be provided), combined with technology, has given the retail investor a much larger tool kit of information with which to make a decision. 

As for institutional investors, they were paying a lot of money for research in order to make investment decisions. The institutional investor was already selecting the best research from the best analysts. The settlement created a lot of “me too” research. This wasn’t necessarily the best research, but it gave more perspectives for the benefit of institutional investors.

INDEPENDENT RESEARCH

MCCLELLAN:

Research of the future will be more specialized by audience. Firms will have to choose whether to serve retail or institutional investors (just like what Piper Jaffray did in choosing to serve institutional investors exclusively). You can’t serve both.

We may also see a bifurcation, in which firms provide either trading research or investment research. Right now, for example, the institutional investor is more trading oriented.  I think we will have less research, but better quality. 

We’ll also have more specialized research boutiques that will focus on a single industry sector such as energy or financials or consumer goods. And research will also be more independent and probably spun off as disparate and independent research units that operate at arm’s length so that they won’t be so dependent on investment banking. These will operate like consulting firms and be paid for with hard dollars, versus soft-dollar funding. 

 LEGGETT:

The Global Research Analyst Settlement definitely put a spotlight on independent research companies. The lion’s share of them had been mom-and-pop shops. But now you’ve seen a professionalization of the independent research industry. With the current market downturn, the buy and sell sides will only pay for those independent research services they perceive to offer the most value. The firms that can differentiate themselves and add the most value will benefit. But there will be a consolidation among independent research providers, which will yield fewer but stronger vendors. 

KASTNER:

There are some very good independent fixed-income research firms out there, but they need more internal credit staff. The problem for the sell side is that it costs money to subscribe to these or to have a credit research staff in-house. There are some great companies out there providing great services. But they will be competitively challenged. 

BROWNING:

There are a few independents that have been successful. Once an analyst has a good reputation, he or she can go to an independent firm. There are opportunities, but they are limited. The opportunities at large banks are dramatically better. Large investment banks will continue to exist. If a company wants a $10 billion rights offering, they’ll need a large bank’s depth of experience and research. 

LEGGETT:

I believe the way the buy side is going to analyze the value of research will be based on meritocracy. The smartest people on the buy side will choose the best-in-class providers in a mosaic of providers that will be chosen to work in partnership with buy-side firms. Each will choose the best of breed for their needs. No one firm is good at all research.

We have seen the huge growth of “expert networks”—there are some 30 of them now—that the buy side can consult with. They pay them a fee to access working experts in the field who can, for example, give an informed opinion on a particular drug trial in which a pharmaceutical company might be engaged. But consolidation and tightening budgets will see these reduced.

MCCLELLAN:

Research will be available for anyone who wants to pay for it, but it won't be subsidized. If the sell side does spin off its research divisions, I think we may see soft dollars disappear altogether, making research more autonomous, more objective, and much more transparent.

BROWNING:

There already is unbundling of research from sales now. According to Greenwich Associates, 46 cents of every comission dollar goes to advisory services. Unbundling has helped us put a value on research. In Europe we are unbundled and research is absolutely flourishing there.

MCCLELLAN:

I believe we will see compensation changes on the sell side. Compensation will be based on the quality of the research versus popularity polls. If research is for an institutional investor, the securities analyst will see compensation based upon how the performance was for the quarter or the year. For retail investors, it will be based upon how the analyst’s recommendations do over, say, three years. Compensation and the evaluation of analysts in general will be a lot more objective and quantified. 

Of course, these are all sell-side changes. But analysts on the buy side will inevitably be forced to play by the same rules as the sell side. Under these rules, there will be no on-the-road or secret meetings. On the corporate side, changes will be in store for corporate executives as well. In the future, bad-mouthing of analysts won’t be tolerated, nor will giving some analysts special privileges. In this way, there will be no biased research. 

GLOBALIZATION

BROWNING:

A lot of the changes to the securities analysis industry will be driven by the markets and profit opportunities. For example, we recently launched our clean-tech coverage. This is an example of changing with the times. 

There is also growing coverage of China, Brazil, and India. But to provide that research you really have to have a local presence on the ground in the country. 

That speaks to the globalization issue. I do believe in globalization. We now have, for instance, 60% of our research analysts based outside the US. That was not the case in the 1990s. We are having a slow build-out of our securities analysts abroad. Some industries, such as metals, mining, and oil, even real estate, are global industries. Most of our analysts were hired within their local markets, but we have successfully moved some to non-US locations. 

JOHNSON:

We are seeing much more demand in Asia—especially in India and China—and in Europe than in the US for the CFA program. For fiscal year 2008, almost one-third—about 32%—of all CFA program candidates were from the US. That means 68% were from other regions. Right now, that number is even lower: around 28.5% in the US, 71% from candidates in other countries.

There may be differences cross-culturally, but we’ve found that as far as knowledge, skills, and abilities, there is very little difference across regions as to what is important.

KASTNER:

China and India are big growth markets on the equity side. But as they begin to develop bond markets, there will be very attractive opportunities for global analysis.

That’s not to say that securities analysis functions should be outsourced. Some people have asked, “Why not just have black boxes or outsource the research?” Having it outsourced is not practical. You want to have an individual who is accountable for the research and is having conversations with the portfolio manager. You want a team working together with the credit analyst and interacting with the manager. At times, the credit analyst may be like the traffic cop who can say to the manager, “Don’t do this, it’s a bad investment.” 

Teamwork is critical. The credit analyst needs to know his or her job inside and out. It is somewhat of a cut-and-dried business. But analysts will need to work as part of a team. Junior analysts will be learning while more senior analysts can challenge portfolio managers when needed. 

BROWNING:

I believe there will be more use of outsourcing, but only as it relates to data collection or fact checking. You can’t outsource client interactions or judgment. 

Globalization will change the requirements for successful securities analysts. A global analyst will need to broaden his or her view and will need to work well together and collaborate with others from many different cultures, often remotely. Sometimes, that is a different skill set. Successful companies will find ways to eliminate siloed analysts and find ways to get analysts to work together in teams and across time zones.

I think just plain questioning is coming very much back into vogue. When I was an analyst there was no earnings guidance. Not only will companies face much more credit analysis by securities analysts, but doubting, questioning, stress-testing, and so on. In the last year or so we have seen a lot more of this taking place. 

CREDIT ANALYSIS

BROWNING:

Credit analysis is something that is going to be very much focused on and important from now on.

 KASTNER:

Credit will certainly become much more important. In 2009, there will be an uptick in corporate defaults. It will be those who can do the credit analysis who will be on top. And I do think that credit analysis will stay. I think the future is very bright for fixed-income analysts. 

Now people suddenly get it. People, especially the baby boomers who are retiring and will need income, will focus more on income in general. Those fixed-income managers who underperformed will be fired and changes on the buy side will be made to have better portfolio managers with solid credit analysis teams in place. 

The credit analyst of the future will have a difficult job, especially given the proliferation of off-balance-sheet items (such as special purpose vehicles). Credit analysts can’t just look at the balance sheet any more. They will have to look much more closely at counterparty risk: how a company is doing, what it is doing, why, and with whom. 

For items like derivatives or commercial paper, analysts will have to figure out where corporations are getting their funding and with whom they have ties. Analysts will also have to be more insightful with regard to what’s going on, not just in their coverage areas, but overall in the markets. 

There is psychological damage that has been done to investors. Before 2008, all fixed-income managers’ performances were typically within 15 basis points of each other. They built portfolios using household names—not companies with great credit. Before 2008 many managers deemphasized the credit analysts, who were relegated to second-class citizens while the portfolio managers called the shots on the fringes. That affected performance. 

Of 66 fixed-income funds, two-thirds didn’t beat their benchmarks last year and some were in negative territory. Lots of managers were down 20%. You can’t get that back. 

They had clearly moved away from good old-fashioned credit analysis. Fixed income has been easy for too long and they lost track of the importance of proper credit analysis. They also lacked a sell discipline, which had many holding Fannie Mae and Freddie Mac far too long. On the fixed-income side it is important to know the credit and do the necessary work. 

CREDENTIALING

JOHNSON:

CFA Institute periodically conducts a “practice analysis” to determine what skills and needs our members have. We did our first practice analysis in 1995. What we found out with our latest one is that derivatives will be a much more important part of the curriculum in the future. 

You know, when we add elements to the CFA program, people think we are giving those elements our blessing, but that isn’t true at all. The CFA program’s goal is to give individuals the skills, knowledge, and ability to operate in the current environment. 

MCCLELLAN:

We’re going to see more professional qualifications for securities analysts, such as MBAs, or a statistics degree, and the CFA designation. I also think that a number of years of industry experience will be required of analysts before they will be able to issue opinions, just like surgeons who must first do a residency. These requirements will make them much more professional. 

JOHNSON:

I do believe there will be a greater emphasis on credentialing, which has become an extremely important signal for employers.

There is more need for education in the financial services sector, but the industry has been shrinking. It has become a less attractive sector for the young, who are lured by high profiles and high dollars. There are fewer new candidates, which means more competition.

The CFA program actually used to be an institutional equity analyst designation. But it has become more broadly defined. Since we’ve moved from defined benefit plans to defined contribution plans, more people are responsible for helping others manage their retirement assets. We’ve found that, increasingly, CFA charterholders are managing private client assets. Analytical skills are trans- ferrable—from institutional wealth management to private wealth management. There may be other things you will need but the concepts and principles are the same, with some minor differences.

 HERE TODAY, TOMORROW, NEXT WEEK

BROWNING:

One of the biggest challenges that I foresee will be to understand new risks and how to fully appreciate these new risks. That is something that could be an opportunity or a long-term problem. For example, analysts will have to look at new regulations and government intervention and be able to appreciate and assess those new risks. 

I think just plain questioning is coming very much back into vogue. When I was an analyst there was no earnings guidance. Not only will companies face much more credit analysis by securities analysts, but doubting, questioning, stress-testing, and so on. In the last year or so we have seen a lot more of this taking place. 

MCCLELLAN:

We will see less quantitative research and modeling and less earnings estimation going forward. We will see more investigative research, more in-depth assessments of management, of a business, of competitors—like it was 30 years ago. Almost like Back to the Future

KASTNER:

New analysts should be looking into the high-yield bond sector. These bonds are the cheapest they’ve been—ever. And the job of the fixed-income analyst requires a lot of work, but it is both intellectually and financially rewarding. 

I think right now is a once-in-a-lifetime opportunity. Investors are badly burned and they don’t want to jump back into the stock market. But they don’t want to hide.

Lori Pizzani is an independent journalist based in Brewster, New York. 

Illustration by Mark Andresen.


This article was originally published in the Spring 2009 issue of the Investment Professional.

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Brokers should also understand that, in many cases, the regulators don't care if you have permission to sign someone's name to a document. In the securities world, oftentimes because of a deadline, a customer may ask a broker to sign his or her name to the document, and the customer gives the broker permission.

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