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Independent Research: Salvation in the Middle Market

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Illustration by Mark AndresenThe ghost of Eliot Spitzer that has haunted Wall Street for the past five years has finally been laid to rest. After his investigation into allegations that the major Wall Street firms had mishandled conflicts of interest between their research and investment banking arms, the now-disgraced former governor of New York trumpeted the global settlement as a victory for retail investors over greedy Wall Street titans. He accused the Street of publishing favorable research reports on investment banking clients even though in private the analysts sometimes derided the companies as garbage. Spitzer’s targets never admitted fault, but in his trademark style, the then–attorney general of New York wrested payments from 12 securities houses, which agreed to fund independent research for five years and make third-party reports available to retail clients alongside their own research.

Spitzer’s levy ran out at the end of June. Yet, while independent research firms can no longer count on the subsidy mandated by Spitzer, and the financial crisis has crimped research budgets, their world has not come to an end. Independent research has always depended more on support from institutional investors than the retail market anyway. And the vast majority of independents will not miss the money because they never reaped one thin dime from the settlement.

Michael Mayhew, chairman, founder, and global director of research at New York–based Integrity Research Associates, says only 60–70 firms received settlement money, an “extremely small percentage” of the independent research industry. A few large firms, including Standard & Poor’s, Argus Research, and Morningstar, got the lion’s share of the settlement money and will feel the loss of the subsidy the most, but they all have other revenue streams.

Mayhew reckons that independent shops have increased their market share during the past five years, but says that Spitzer’s settlement was not the driving force: Regulation FD (Fair Disclosure), which banned selective disclosure by public companies, has had a bigger impact. Since implementation of that rule, if companies make information public they have to make it available to everyone on an equal footing. “Sell-side analysts no longer had the inside scoop on the earnings numbers,” states Mayhew. Buy-side firms looking for an edge began to hire more analysts to do primary research in house or tapped independent research firms—and often did both.

Filling the Research Gap

Today a successful independent research firm has to offer a unique value proposition. Traditional written reports will not do the trick anymore unless they are supplemented by channel checks, data feeds, or models that the firm makes available to clients. Unconventional research channels such as expert networks have intrinsic value, too, which explains their growing popularity among investors on the cutting edge.

Independents are fighting for a piece of a shrinking pie, however. The collapse in asset values and unremitting downward pressure on commission rates are squeezing the pool of soft dollars from which independent firms get paid. Although independents typically have no execution capability themselves, most clients pay through soft-dollar conduits so that lower commission rates flow straight through to crimp the research budget.

The Spitzer settlement forced Wall Street to revamp analyst compensation to end rewards for generating investment banking business. As research budgets dwindled, some big-name analysts jumped ship to set up their own independent shops. Others went to hedge funds, which enjoyed rapid growth in assets under management before the financial crisis took hold last year. Wall Street firms cut the number of companies their analysts covered—and the crisis has only made matters worse. “We are not seeing coverage on a lot of small-cap and even some mid-cap companies,” says Mayhew. “The Street can no longer afford blanket coverage.”

Independent research firms have helped fill the gap. Stephen Biggar, global director of equity research at Standard & Poor’s in New York, notes that his firm has increased its equity research coverage from 1,300 companies to 1,550 in the past five years. It has enhanced its research product, too. Besides traditional investment recommendations, S&P reports now offer qualitative assessments that grade companies by the riskiness of the business environment in which they operate—acknowledging the difference in earnings sustainability between a biotech and a utility, for example. “The qualitative grading helps in portfolio creation. If you are building a portfolio you may not want to have all your stocks in a high-risk category.”

Standard & Poor’s always knew that the settlement money would run out, so it has tried to make its research indispensable to customers. A strong track record of buy recommendations that outperform the benchmark and sell recommendations that underperform is the ultimate marketing tool, but Standard & Poor’s also focuses on timely comment that is actionable. “We don’t put names or under review,” says Biggar. “If a news announcement comes out, we will take a stand.” The strategy appears to have worked: Standard & Poor’s is in discussions to continue contracts with many of the Street firms to which it provided research under the settlement.

In the absence of Spitzer’s mandate, Wall Street houses buy independent research either to augment coverage beyond the companies their own analysts follow or to provide a second opinion on research from an independent source. As a revenue stream for Standard & Poor’s, discount brokers like TD Ameritrade, Charles Schwab, and E*Trade dwarf the integrated securities houses, however. “The research is available directly to discount brokerage customers,” observes Biggar. “This is for self-directed investors.” Standard & Poor’s also sells its research to regional banks, insurance companies, and corporate libraries. The settlement revenues were a nice bonus for Standard & Poor’s, but never the core of an equity-research business that is more stable than most because the firm sells its research under multiyear business-to-business contracts that stipulate hard-dollar payments.

Like Standard & Poor’s, Chicago-based Morningstar offers broad research coverage: it has more than 90 analysts who cover more than 130 industries. Cathy Odelbo, head of securities research, states that the company’s research originally targeted a retail audience, playing off Morningstar’s long-standing connection with individual mutual fund investors. After the Spitzer settlement kicked in, Morningstar also developed an institutional business among money management firms, mutual fund complexes, pension plans, and state retirement systems. Some customers do value the fact that the firm is independent, but by no means all. “What the buy side really cares about is great ideas and great service that they can count on time and again,” says Odelbo.

Morningstar tailors its research product to meet each client’s particular needs. Odelbo says some firms buy research for just a couple of sectors, while others take broad coverage as a way to outsource the research function. Many clients like to have access to Morningstar’s valuation models, too. “It saves them a lot of time. As long as they trust our methodology, those models are valuable to them.”

Although Morningstar has clients of every size, the strongest demand comes from traditional money managers that have $1 billion to $20 billion under management. Odelbo says that this group gets less attention from the sell side than it used to, having been pushed aside by hedge funds, which generate much higher commissions than conventional firms of similar size. A long-only money manager that does not do much trading will not get one-on-one access to Street analysts anymore and may not even be invited to conference calls. “You are not really on the sell-side radar unless you have hundreds of billions in assets. It’s very attractive to smaller firms that they can talk to our analysts.”

Boutique Firms

The broad-based independent research houses do not have the market to themselves. Scores of smaller boutiques have carved out a niche by providing in-depth coverage of particular industries or subsectors. Ben Rose, the founder of Battle Road Research in Waltham, Massachusetts, set up his firm in October 2001. During his 10-year career as a sell-side analyst, Rose witnessed firsthand the conflicts of interest that spurred the adoption of Regulation FD and the effects of that rule’s implementation. Today Battle Road has five analysts who cover 72 stocks in four industries: technology, health care, solar power, and education. The firm started out with an institutional focus and only participated in the Spitzer settlement program in the last two years. “We had a product that could appeal to financial advisors and their clients,” states Rose. “We came to the settlement belatedly but I am confident we have relationships in place that will survive.”

As Rose points out, even though Wall Street cleaned up its act, sell-side research reports still come with extensive disclaimers about the relationships between and overlapping interests of the securities houses and subject companies. “There remains a caveat emptor, that what you are reading should be taken with a grain of salt,” he says. Independence removes the taint of entangled interests, but Rose sees that credibility as a necessary though not sufficient condition for his firm’s success. Research has to provide added value to clients, whether through channel checks that try to monitor sales trends or industry sources outside company management that can offer a different perspective on how a company and its competitors are doing. Battle Road uses both methods to prepare a traditional written product with buy, sell, or hold recommendations based on a combination of financial analysis and industry input.

Battle Road’s clients run the gamut from mutual funds to bank trust departments and hedge funds. “We are a credible second source,” remarks Rose. “We are not saying we are the only source or the ax in the stock. But wouldn’t you want one more opinion on a critical holding, knowing that we are not receiving any compensation from the company?” Like most independent research firms, Battle Road gets paid in hard dollars, although clients typically apply commissions by routing trades through a soft-dollar broker that actually cuts the check.

In addition to producing written reports, Battle Road arranges meetings with company management, for which Rose sees “unlimited interest” on the part of institutional investors despite the restrictions Regulation FD imposed. “If you are going to take a multimillion dollar position in a stock you would like to know whether the CEO can show up in the office looking respectable,” says Rose. “A polka dot tie and striped suit might send a signal to some people that the stock is a sell.”

He finds that companies abide by the Regulation FD and will refer back to their last public statement if an investor at a one-on-one meeting asks a question that crosses the line. Rose takes comfort from that because Battle Road prefers to generate research from public documents and its proprietary network rather than company officials. In the early days, the firm would launch coverage without ever having talked to the subject company, but Battle Road is a little more open to hearing the insiders’ perspectives today.

Rose would like to increase the number of sectors Battle Road covers, but he is in no rush and will not stray too far from the firm’s core expertise. “Research is awfully difficult to scale. One bad call in one sector you cover raises suspicions about the value you can add.” Before he launches new coverage, Rose wants to understand what investors are not getting from existing coverage and how Battle Road’s expertise can address those shortcomings.

Expert Networks

The specialized research that firms like Battle Road provide has particular appeal to hedge funds, which try to gain an edge any way they can. Hedge funds have also propelled the growth in expert networks, an alternative source for research that has come to the fore in the last 10 years. “People who work at hedge funds, private equity firms, and proprietary trading desks need to perform from an investment perspective,” says Aaron Liberman, managing director of US sales at New York–based GLG (Gerson Lehrman Group), by far the largest expert-network firm. “The only way to do that is to know your stuff better than the next person and gain insights and inputs on emerging positive and negative trends.”

Expert-network firms do not produce research themselves; instead they facilitate primary research by providing access to people who have intimate knowledge of the topic in which a client is interested. In 10 years GLG has amassed a database of 210,000 experts located all over the world, including consultants, academics, retired company executives, people between jobs, and even some current employees (who must have their employers’ consent to join the network). The firm has about 850 clients, more than half of which are hedge funds. One quarter are private equity shops, and the rest includes investment banks’ asset-management arms, traditional asset managers, lawyers, and management consultants.

If a client wants to know about solar power manufacturers in China, for example, GLG will search its database to identify potential candidates and arrange introductions to however many the client wants to talk to. Most discussions take place over the phone—GLG personnel do not participate in the calls—but GLG sometimes sets up site visits where an expert will address a small group (the managing partners at a private equity firm, for example). GLG also conducts surveys and helps clients find panelists to speak at investor conferences.

In addition to providing access, GLG enforces a rigorous compliance regime to ensure that experts do not pass on inside information that could get clients into hot water if they trade on it. Expert networks like GLG give buy-side clients who want to do original research a more voluminous version of the industry Rolodex that sell-side analysts have always relied on to flesh out their insights. Clients do not have to share the experts’ knowledge with anyone else, either.

Feedback from GLG clients suggests they plan to dedicate more of their research budget to expert networks to plug the gaping holes in Wall Street coverage. The financial crisis has squeezed margins at the securities houses so hard that they have stripped away marginal coverage to focus their research only on the most profitable areas. “If a sell-side firm doesn’t see how it can make a profit by covering the airlines, for example, they won’t do it,” asserts Liberman. “Ten years ago that was sacrilege. You pretty much had to cover the waterfront unless you were in transition.” Prior to joining GLG in 2002, Liberman was in charge of North American equity sales at Deutsche Bank for two years and worked at Goldman Sachs for 14 years before that.

Exchange-Sponsored Research

An estimated 1,400 US public companies have no research coverage at all, so stock exchanges, worried that dwindling research coverage will cause the stock prices of orphaned companies to languish, have begun to sponsor independent research. In May 2009 NYSE Euronext struck a deal with Virtua Research to make financial models of underresearched companies available on the NYSE website. The following month NASDAQ OMX inked an exclusive agreement under which Morningstar will provide research profiles of companies listed on its exchanges.

The Morningstar profiles describe the companies’ businesses, give summary financial data, list principal officers, name the largest shareholders, and show recent changes in ownership. A final section gives background information on the industry and competitors, but the reports do not ascribe Morningstar ratings or give investment recommendations. “It gives a good overview of the company and its industry,” says Bruce Aust, executive vice president of NASDAQ OMX. “It’s not going to have a buy or sell rating. That makes it easier for us to provide reports for all our listed companies.” The profiles cover 3,600 companies listed in the US and the Nordic countries.

NASDAQ OMX already offers investor relations, corporate governance, a news wire, earnings webcasts, and other support at no additional cost to listed companies. Aust sees the research profiles, which are available on both the NASDAQ OMX and Morningstar websites, as one more service the exchange can provide to help companies get their messages out to investors. “We believe an exchange should be more than just a trading venue. It is all about how we can add value to the companies that are listed on our markets.” Morningstar was a natural partner, too. Since the firm went public in 2005, its shares have been listed on the NASDAQ.

Research sponsored by a stock exchange avoids the stigma that has always been attached to paid research, which Integrity Research Associates has tracked for years. Mayhew contends that investors treat paid research as the lesser of two evils—the greater being no coverage at all. He points out that self-selection may account for part of the inevitably positive bias in paid research. “The firms either know they are good and that nothing bad will be said about them,” says Mayhew, “or they are really bad and trying to pull a fast one.” He believes that sophisticated institutional investors understand the conflict of interests and evaluate paid research in that light.

The New Paradigm

While traditional written reports still have a place, they are by no means the highest priority for the buy side. A survey conducted by Greenwich Associates, a consulting and research firm based in Greenwich, Connecticut, found that institutional investors rank written research only fifth in importance, after analyst service, access to management, sales coverage, and research conferences. Institutional investors want access to analysts’ models, too, so they can test the sensitivity of valuations or tweak the assumptions to match their own economic forecasts.

Based on feedback from Greenwich Associates’ buy-side clients—mostly large, institutional money managers—only 35¢ of every research dollar goes to pay for company and industry studies, macroeconomic reports, and other printed material. Another 20¢ pays for corporate access, and 10–15¢ for conferences, which investors increasingly view as another venue at which they can talk to management at one-on-one meetings, away from the main presentations. Access to analysts accounts for about 25¢, and sales support makes up the rest. “Institutional investors today want access and insight,” says Jay Bennett, a managing director at Greenwich Associates. “They are much less dependent on the publishing-based model.”

The new paradigm fosters a symbiotic relationship between the largest money managers and the big sell-side firms, which not only provide research and corporate access but also will continue to dominate the calendar when initial public offerings revive. “I don’t know how the smaller institutional money management firms are going to get service,” states Bennett. “The bulge-bracket firms are happy to let people run trade flow through their electronic portals, but smaller managers will have less of a call on analysts or corporate access.”

The demise of Bear Stearns and Lehman Brothers along with the shotgun marriage of Merrill Lynch and Bank of America put about 15% of the research budget up for grabs, but the Greenwich Associates survey shows that independent shops have not been able to capitalize on the opportunity. Bennett notes that about half of the money went to the stronger bulge-bracket firms and the rest to regional investment banks; the independents were left out in the cold.

Integrity Research Associates confirms that regional brokers have picked up market share, driven in part by the recognition among investors that trading with these firms carries less risk than doing business with a major integrated securities house. “Regional firms don’t have proprietary trading operations or a significant exposure to credit default swaps, commercial real estate, and so on,” says Mayhew. “They are getting more execution business, and the firms that produce good research are getting paid for that, too.” The shift has triggered a hiring spree by firms like Jefferies, Buckingham Research, and RBC Capital Markets, which are stealing analysts away from UBS, Goldman Sachs, Merrill Lynch, and other bulge-bracket firms.

The raw numbers do not necessarily tell the whole story, however. John Eade, president of Argus Research, a leading independent research firm based in New York, points out that hedge funds are aggressive consumers of independent research and expert networks. In the last year, however, many funds have closed down and industry assets under management have shrunk by about 40%. If independent firms have preserved their market share against that background, they must have picked up some new business from traditional money managers.

In addition to equity research, Argus Research sells data on insider and institutional shareholdings, and has a money management business. Over the past couple of years, it has expanded its research service beyond traditional written reports. Building on the relationships its 25 analysts have cultivated with the companies they cover, Argus Research rolled out a corporate access product. The firm hosts road shows and one-on-one meetings, as well as small group lunches and dinners with corporate management—a service that has proved popular with both hedge funds and long-only money managers. Before Regulation FD took effect, these intimate gatherings used to be the exclusive preserve of the big sell-side firms, but Eade maintains that the new rules blunted the sell side’s inside edge so that independent research shops can now provide equal access.

The product has broad appeal, but resonates particularly with middle-market money managers who are not typically among the 10 or 15 largest shareholders. “The giant investment institutions are still served by the sell side,” remarks Eade, “or they can get their own meetings with the companies.” Argus Research’s success with smaller managers illustrates how difficult it has become for those firms to get the support they need from the sell side today.

The Future of Independent Research

Eade is less optimistic about the future of the conventional research reports and ratings that were at the heart of the Spitzer settlement. Although Argus Research will continue to supply research to some bulge-bracket firms, Eade says prices are under pressure now that what was essentially a fixed-price regime under the settlement has ended. Independent research firms tend to be more nimble than the major securities houses, however, and can take advantage of emerging opportunities—as Argus Research did when it found a new outlet for written research in a program organized by the London Stock Exchange to provide research coverage of smaller companies. Eade observes that independent firms that have money management arms have also started to offer “alpha-capture” vehicles—concentrated portfolios that track a handful of their best research ideas.

The independents need to have their wits about them to survive in a world in which money managers face intense cost pressures after the precipitous fall in asset values blew a huge hole in their top-line revenue. Commission budgets will be lower in 2009, and independent research is bound to feel the effect. Integrity Research Associates estimates that independents reaped $2 billion in 2008 but Mayhew expects a significant drop in industry revenue this year. Although he foresees a rebound in 2010, future growth will be from a lower base.

Independent research firms ought to benefit from the wider adoption of commission-sharing agreements by institutional investors. These arrangements allow investors to split their commissions between a broker and a separate pool to pay for research. That could be the broker’s own research, but Mayhew says investors often use the money to pay for independent research. “It’s the beginning of unbundling on Wall Street. Pension funds and other investors don’t know how their commission dollars are being spent.”

Mayhew argues that money managers tend to direct more order flow—and commissions—to the sell side than their need for research dictates. Some of the excess pays for corporate access and sales support, but the real driver is the desire to ensure managers receive allocations from initial public offerings. “This should be a perfect time for the independents to take market share,” asserts Mayhew, “but it is not happening.”

Despite the challenges independent research firms face today, Mayhew remains upbeat about their future. He attributes almost all the innovation in investment research to the independents, and as long as they continue to develop products that assist investors’ relentless search for alpha, he expects them to prosper. “The independents are closest to the customer. They understand what the customer is interested in, and, more importantly, will pay for.”

–Neil A. O’Hara brings 29 years of experience in the financial services industry in London and New York to his second career as a freelance writer. His work has appeared in Institutional Investor, Alpha, FTSE Global Markets, and the New York Times, among other publications.

Illustration by Mark Andresen

This article was originally published in the Fall 2009 issue of The Investment Professional

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