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| Trying to erase the taint of bias and conflicts of interest that have dogged sell-side research in recent years. |
CORPORATE PENSION FUNDS are wasting money investing in the stock market. That’s the conclusion Stephen Cooper and David Bianco reach in a report they published last month entitled Should pension funds invest in equities? Or, to add a small caveat, that’s the conclusion they reach for companies with defined-benefit pension plans to manage.
It’s a valid and contentious topic. And this is the sort of research you’d expect to see being published by consultants or academics. But the authors of this report happen to be research analysts at UBS, an investment bank that has one of the dominant equities franchises in Europe and Asia and is trying to build a similar platform in the US.
Here are two of their own recommending that a large section of UBS’s clients avoid precisely that product, and avoid it for good. That’s a lot of potential commission and trading revenue the bank might lose out on.
Yet the authors still have their jobs.
Their report is symptomatic of what most investment banks are now trying to achieve: to eradicate the taint of bias and conflicts of interest that have dogged sell-side research in recent years, and especially since New York state attorney general Eliot Spitzer went public with his investigations last year. It’s not that sell-side research has had no value whatsoever in the past few years. Institutional investors, for all their moaning about research being biased to flatter companies the sell side wanted to win investment-banking business from or about recommendations being meaningless, could always find value somewhere. It might be a good, thoughtful piece on a key industry sector trend, an analyst who could get them in to see senior management of an interesting company, or just someone to crunch the numbers for them.
Spitzer’s investigations highlighted the worst elements of sell-side research and hit investment banks’ reputations hard. And across the industry there is now a desire to be seen to be changing.
Keep it clean
Bill Kennedy, global director of research at Smith Barney, says: “Research is going back to the future – hard core, fundamental, bottom-up research.” It’s going to take a lot of work to convince investors, though, and they are getting increasingly demanding. “We were looking to hire someone to replace a pharmaceuticals analyst,” says the head of equity research at a major Wall Street firm. “A headhunter offered me one promising name. He had great ideas, and his client list shocked me because it had so many major names on it. He didn’t do maintenance research, but was always on the road, calling in ideas from medical conferences and the like. Some investors rang me up and told me that if I hired him I wasn’t allowed to pervert him.”
Some banks still seem unsure what they should be doing with their research product. “Our clients on the buy side don’t know exactly what they want from sell-side research yet,” a senior executive at an investment bank in the US told Euromoney over the summer. “And until they do, we won’t know exactly what to offer them.” Others are not quite so circumspect.
“What the buy side wants is fairly straightforward,” says Tim Bixler, co-head of equity research boutique CSFB Holt. “Something that makes them money.”
That, in short, is what the investment banks should be striving to offer. To put it in that terrible banker-speak, they need to offer a value-added product. “It’s a pretty simple model,” says Smith Barney’s Kennedy. “But it’s one that’s been lost in the noise over the last five years.”
At present, though, most of the banks are still in the early stages of their new research strategy. “I think we’ve got one or two years of institutions trying out different approaches,” says Stefano Natella, global head of equity research at CSFB. “Then the winning models will show through and the rest will adapt.” There’s another reason for getting it right beyond salvaging reputations; there are now plenty of analysts who used to work
at investment banks who have since set up or joined independent research firms, three of which we profile later in this article. They’re busy touting their independence as one of their key strengths, and have in many cases attracted good analysts. If the investment banks don’t get it right, investors can easily head to these new operations instead.
If there’s one part of the process that all seem to agree on, it’s the role of maintenance research – reacting to commonplace events such as earnings announcements, management changes and even acquisitions.
It’s out of favour, and the banks are trying to scale back how much of what their analysts do. “It would be a very daring, and risky, model to get rid of maintenance altogether,” says Natella. “The most successful analysts are those who can do both maintenance and more expansive research. But the time value maintenance has is now one hour at best, so communication has to be targeted and efficient.” His initial prescription for more in-depth research is pretty straightforward, and is similar to what many of his counterparts are saying.
Do the job properly
“We’ve increased the amount of investigative and proprietary research we do, relying less on investor relations and press releases, and going out to speak with clients, suppliers, non-public competitors, all the way down the supply chain,” says one head of research. Sceptics will shout that this is precisely what research analysts should have been doing all along. And they’d have a point, although there are plenty of analysts who did precisely that even through the bull market.
But this research head’s outline of his firm’s new approach to the discipline is as close to an admission as you’ll get that the banks recognize that, in certain respects, they failed, and are now trying to shape up.
All the banks are now promoting their newfound desire to produce more valuable research. Smith Barney’s Kennedy says: “We’ve put a big emphasis on getting our analysts to compete on the added value they can provide, using proprietary data, research and surveys as the basis for reports. Our directors and associate directors of research are responsible for querying the analysts on what hypotheses they want to test. About half to three-quarters of such ideas come from the analysts themselves, the rest from customers, the institutional sales team and the financial consultants in the private client group.” One example Kennedy cites is a report last month by US banks and brokerages analyst Ruchi Madan that analyzes the results of a survey she and her team conducted of the investment behaviour of 1,100 affluent investors and what effects that might have on the retail broking sector.
In a second report using the same survey she examines the potential effect on bank earnings if a continued improvement in the stock market leads to investors reallocating some of their bank deposits to equity investment.
The bank that appears to have gone furthest, though, is UBS.
Cooper and Bianco’s report is just one of the latest examples of a research product launched last year called the Q-series, where the Q stands for question. The person behind the Q-series idea is equity product manager Erika Karp. “It’s not just a product but a philosophy,” she says. “It’s based on Socratic dialogue, in which critical thinking, challenging assumptions and constructive dialogue are paramount.”
At the centre of this philosophy, as far as the Q-series is concerned, is the question. It’s startling simple, as with most good ideas, and has the benefit of costing very little to implement. The central feature is the question bank, which is nothing more than a document on a computer for each analyst holding all the questions the bank might be asked about a particular stock or a sector.
The only other requirement is a good number of enquiring minds to ask the questions. And these can come from the analyst, the institutional sales force, the private-client financial consultants, and of course institutional investors – who will usually pose the question to the analyst or salesperson who will then put it into the question bank.
Those who ask the questions, by the way, remain anonymous.
Frequently asked questions
The next step is just as simple: the analyst considers the questions, and decides whether there is a theme that could be addressed in a form that might help buy-side customers in their investment decision-making process. Investors that are clients of UBS can also ask to see the questions others are asking at any time.
“The question is the single common denominator, and what we’re doing is to conduct research that values the questions as least as much, if not more than, the answers,” says Karp.
She points out: “It’s very different to how research has traditionally been done at investment banks. This is a paradigm shift. We’re moving away from the idea that our opinion must always be right to add value because it’s from Wall Street, towards the premise that we are helping to form opinions.”
Karp has insisted on just four conditions for an idea to be accepted as a Q-series topic: there must be a pivotal investment question; the question should be answered using incremental analysis and primary research; any investment conclusions should be made clear; and it should ultimately address a key sector issue, not be a stock-specific enquiry.
There’s not much more to it than that, nor does there need to be. It hands more power over the type of research produced to the investors it’s supposed to be written for. It de-emphasises news coverage and stock price targets that institutional investors can do for themselves, especially the larger ones that form the nucleus of most major investment banks’ client lists, involves everyone in the process, and still leaves analysts with the independence to undertake and write up their research.
Having started the Q-series project in the US, Karp, who thought up the business plan while she was on maternity leave, has started rolling it out in Europe and Asia, and intends to have analysts in the different regions cooperate on Q-series reports as much as possible.
As yet writing a Q-series report is not a requirement, although more and more are being written and Karp says that most of the US analysts are coming up with a steady flow of ideas. There is also, by extension, no set number of Q-series reports an analyst has to write. “We’re not managing this by the numbers, although I think what I’d like is to see each analyst write one or two a year. I’d say that about 60% of the analysts in the US have published a Q-series report. And the truth is, that’s fine.”
Karp has also been talking to the fixed-income research department about expanding the product into their universe as well. There have long been proponents of offering combined debt-equity reports, or what some are now calling total research. Traditionally, credit analysts have been pessimists, looking for downside protection and equity analysts optimists seeking growth potential.
Calls to merge the two, or at least to have more cooperation between those on either side covering the same companies or sectors, have increased in the past three years as a result of the effect of stock price volatility on balance-sheet and debt-structuring problems.
Fully merging the two looks unlikely to happen, though. “We’ve got fixed income and equities working more closely,” says Natella at CSFB. “My take is that the key is to improve communication between the two groups.”
There’s also a move at several banks to publish more combined reports in which a sector analyst – or more than one if covering related industries – works together with the bank’s economic, strategy or quant research analysts.
Cutting down on coverage
CSFB is hoping that it can pick up some business by taking advantage of the moves many of its rivals have taken to cut back coverage of stocks deemed too small, too unimportant and therefore usually too costly to warrant a piece of the ever shrinking research budget.
“We don’t cut back our coverage without good reason,” says a source at Goldman Sachs, which has cut the number of companies it covers to 1,600 from 2,000. “Those we have cut were the result of falling stock prices reducing company market caps to a point where institutional investors were no longer following them.”
Most banks have done the same, which has exacerbated an existing problem – too much coverage of the big companies at the expense of the others. “For example, the largest software company might have 30 analysts covering it,” says Natella, “whereas the smallest company in that space has just three.” It’s an area that the independent boutiques are hoping to fill but so, to an extent, is CSFB, mainly by using Holt, the research boutique it bought at the beginning of 2002. It had more than 350 clients at the time of the acquisition, 95% of them on the buy side, and covered 18,000 companies in 28 countries. It’s best known for its valuation database which monitors and updates disciplined discounted cashflow (DCF) models.
CSFB is using Holt to expand its coverage of small-cap and mid-cap stocks. “In the US Holt’s team of nine people will monitor 2000 stocks. They will filter that number down to 400 which we will actively evaluate,” says Bixler. “After meeting with management, studying industry trends, utilizing Holt’s global database and analyzing alternative scenarios, the team will come up with and market a focus list of between 60 and 80 stocks.”
The bank is also using Holt to improve its overall work on valuation. “Since the acquisition, we’ve rolled it out to CSFB analysts globally who use it as a tool to enhance their research,” says Bixler. “And 750 institutions now have it on their desktops.”
He says that all US analysts have been through the training, and estimates that 65% of them now incorporate Holt into their research reports, higher if the financial sector analysts are excluded. Holt, as with other models including KMV’s product and CreditGrades, is not best suited for analyzing financial companies.
CSFB is not the only one to put more emphasis on improving valuation. Another is Smith Barney, explains Kennedy. “We’ve instituted fundamental standards, to make sure that every recommendation has a good basis in fact. We’re increasing focus on valuation, and putting more emphasis on risk assessment.”
One of the ways it’s doing that is by employing outside experts, he continues. “A major step we’ve taken is to bring in a professor from a major university to get our analysts up to speed on the latest cutting-edge valuation techniques.”
Whether these changes – refinements, rather than new initiatives, for the most part – are successful will take time to determine, at least the two or three years that CSFB’s Natella suggests. How exactly their success can be judge is another matter.
How to pay for research is likely to remain a hot topic at investment banks for some time, but there are some pretty simple methods of working out whether or not investors find the research valuable. “We will put more emphasis on clients’ broker appraisals and the Greenwich survey, which has a section on creativity of research ideas,” says Kennedy.
In fact, independence of thinking, whether from their own firm or from other sell-side analysts, ranks as the characteristic that is most prized by the buy side in a survey Greenwich conducted in the first three months of the year. Kennedy says: “We also examine, along with the equities management team, what the knock-on effects are on trading and commission flow.”
Trading flow rewards research
That would appear to be the most obvious way of reckoning success, given that revenue from investor trading ought now to be the main way of funding sell-side research. It’s something Karp has also been monitoring at UBS. She has noticed a sharp pick-up in trading flow coming the bank’s way after certain Q-series reports have been published.
For now, though, the priority, even above enhancing revenue, is to be to be seen to be offering something of value to investors. “I think we’re doing work that wouldn’t previously have been done at an investment bank,” says Karp. “We’re trying to be intellectually honest, such as with the report on corporate pensions and equities.”
Whether intellectual honesty can sit comfortably within investment banks also desperate to turn a profit might prove the most interesting question of all.
| Glenn Reynolds, Paul Ciasullo, Peter Petas |
CreditSights
Analysts who pull no punches
Hindsight suggests that the founders of CreditSights were blessed with the gift of perfect timing in setting up a credit-focused independent research firm in late 2000, right on the brink of three years of recession, scandals, defaults, severe price shifts and changing investor needs.
But the founders admit they took a bit of a gamble with the timing. A group of ex-colleagues who had worked together at Lehman Brothers in the early 1990s started talking about setting up a venture of their own in 1999. Peter Petas, then head of global emerging market debt strategy at Deutsche Bank, was approached to provide credit research content for an online derivatives exchange. “I couldn’t really decide what to do,” says Petas. “I didn’t want to join just another online company.”
Petas talked to Glenn Reynolds, head of corporate bond research at Deutsche, and Paul Ciasullo, a trader by background who was running the foreign bond business in New York for IBJ/Aubrey Lanston, and realized that together they could raise enough money to set up their own credit research company.
All three were fed up with being mired in the internal politics and bureaucracy that came with working for a bulge-bracket investment bank. The prospect of going independent was very appealing. “We had left the Street because we didn’t want people telling us what to do,” says Reynolds. “Before, every time we wanted to sneeze, we had to run it past the lawyers.”
But in 1999, dot-com businesses were already high risk. “Things were heating up and a lot of trading platforms were falling by the wayside,” says CreditSights CEO Reynolds. “We decided to wait for one more bonus cycle before making our move.”
Independence of thought
So having taken a long summer break and armed with one final bonus package, the three set up CreditSights with their own money in September 2000. As Reynolds puts it: “It’s better to be lucky than smart.”
The CreditSights product has garnered wide appeal, combining independent credit strategy and sector coverage in two areas – global corporates and emerging markets, alongside BondScore, a quantitative research tool to measure company credit risk.
It’s the independence of thought that appeals to many clients, not least the tendency to cover, while pulling no punches, the kinds of issues that investors crave to know but bank-based analysts are unable to cover. One good example, and a constant theme over the past two years, is how lending banks might be pushing bond investors further down the subordination ladder. “The fact that the banks and the institutional investors have ended up on opposite sides of the ring in the fight to salvage some recovery value from the current detritus of once investment grade credits is one of the less desirable outcomes from the idea of global one-stop banking that swept the industry in the 1990s,” reads a July 2002 strategy piece.
More recently, CreditSights analysts have been using the data on corporate bond trading prices provided by the NASD and repackaged by MarketAxess to show how investment banks might be fudging the numbers when buying and selling, or refusing to buy or sell, bonds for clients.
Independence counts, and not just in terms of what they can write about. There’s also the question of time. “I can concentrate on actually doing the research here. I don’t have the investment bankers and the trading desk calling me all the time,” says Petas, who heads the product content at the company. It also means that the company can respond quickly to demand for new areas of coverage from investors. For example, it is now focusing on accommodating the huge growth in credit derivatives and convertibles and the convergence between debt and equity.
It turned out that the business model of customers paying for independent credit research could not have been launched at a more fortuitous time. “We had been talking to our clients before we left our previous jobs and they had articulated the desire for this sort of product. We knew the demand was there,” says Reynolds. “What we had no idea about was that post-Spitzer the value of independent research would become so important.”
It turned out that investors did want to pay for this product, but they weren’t lining up to subscribe straightaway. Luckily, the company also had a back-up plan to get the cashflow going. “It took a while to get subscription business going but in the meantime we could do consultative work to keep us going,” says Reynolds.
The team also decided not to approach venture capital companies for funding, which meant that the founders could keep control of the future of the business. It also meant that it could use its equity as a currency for attracting top analysts. Although it paid out a small cash bonus this year, analysts joining initially went without the bonus that they would have been used to at a bank in exchange for an equity stake.
Most internally generated revenue is reinvested in the growth of the business. And after two external stock-raising exercises, 85% of the company is still owned by the employees and the implied market cap of CreditSights is now several times larger that the initial $12.5 million, which makes holding an equity stake pretty attractive.
The pay structure certainly hasn’t stopped them recruiting talented analysts from across the industry. Over the past three years, a further seven senior analysts have followed Reynolds and Petas from their ex-employer, Deutsche Bank, alone.
Ciasullo, who is responsible for business strategy, fund raising, vendor relationships and building out the platform, appreciates the variety that working for such a small company gives him. “In a bigger organization, my job would be divided between about 72 different departments,” he says. All the analysts also have the technology to enable them to add content to the site remotely, which gives them the flexibility to work from home or when they are travelling. Analysts in the US are based in Georgia and San Francisco as well as in New York. In fact, Petas was on a conference call from his holiday in Cape Cod when Euromoney spoke to him.
The night watch
The downside for all three are the hours involved. One of them is often handing over managing the content of the site to another at 4am. “The worst thing about the job is lack of sleep. I think I probably get about 50% less,” says Ciasullo. “It’s been non-stop hard work,” says Reynolds. “In the last two years, I probably haven’t worked so hard since I was 22.”
However, producing several daily email alert deadlines and responding quickly to credit events in a candid manner is what CreditSights has built its reputation on. Reynolds says that not having to produce new-issue research, attend constant internal meetings and deal with increasing compliance pressures like analysts at sell-side institutions gives CreditSights a distinct advantage. “Now we can get analysis surrounding credit events up on the screen well before our competitors.”
Three years on and the company now has 500 institutional clients in 14 countries, at an individual subscription cost of $12,000. It also has 47 employees in the US and Europe, a number it wants to expand.
The team thinks it’s the first independent research company to attempt to build a global debt research platform. The flexibility that remote publishing offers means that they hope to bring on board analysts based in other parts of the world such as Asia and Australia. The proportion of the company owned by employees will creep up as CreditSights adds analysts and grows the content until the company brings in more external funding. The plan is that now the company is a demonstrable growth story, the team will seek to raise some private equity before too long.
It is not just institutional investors that subscribe to the CreditSights service. There is also demand from the credit trading desks of banks, which want something other than their own in-house research. “The trading guys who subscribe to us don’t want a lot of sunshine blown at them from someone who’s been talking to investment bankers,” says Reynolds.
While the sell side is being forced onto the defensive to reorganize its research model, CreditSights is aggressively expanding. “It may be an unfair advantage but we’re happy to take it,” says Reynolds.
Kathryn Tully
New Street Research
Farewell to analytical drudgery
| The New Street Research team |
There are lifestyle attractions to working at an independent research boutique, says Iain Johnston, senior managing director and founder of New Street Research. “You have more control over your life, like what time you come into work,” he says. “There’s no need to be in at seven in the morning. You also get much more control over your travel arrangements.” That’s not the end of the advantages. “As a senior analyst [at a larger institution] you find your diary booked months in advance to fit in with other people’s marketing schedules, which can be really frustrating. Moreover, everyone here is a shareholder and therefore equally and fairly incentivized; the subjective element that accompanies bulge-bracket bonuses is absent.”
Johnston started New Street Research in November 2002, after resigning from JPMorgan the previous May. He has covered the telecoms sector for 19 years and was previously the head of telecommunications research at JPMorgan. He was ranked the number one European wireline services analyst by Institutional Investor in 2001 and 2002.
James Ratzer, who joined New Street Research from UBS’s multi-award-winning telecom research team, was the top-ranked individual analyst in Reuters’ 2001 survey and the number two in Institutional Investor’s 2001 and 2002 survey.
Disenchanted with the stifling work environment, Johnston wanted to do something that was more entrepreneurial and first toyed with the idea of starting a hedge fund. That project never got off the ground but he was approached by several institutional investors that encouraged him to set up an independent research boutique.
Once he’d made up his mind he contacted Ratzer at UBS. “I phoned and said ‘let’s go for a drink,’ and before I’d finished my sentence he said ‘yes’,” says Johnston.
Not all are so willing to leave the security of their prestigious employers, but according to Johnston being a senior analyst at an investment bank just isn’t very stimulating. “There’s a real lack of flair working in research at the bulge bracket. The bureaucracy and structure of the investment banks frustrates a lot of analysts, so tempting others away was really not that difficult,” he says. “There is a very prescriptive process for analyzing and writing research at the big houses that’s linked to the need to service the salesmen, traders, and investment bankers. It’s very mechanical and involves a lot of box-ticking. You end up spending time doing maintenance research that nobody is really interested in reading and that doesn’t add any value,” he says.
“Because we don’t do that type of research at New Street Research we have the freedom to cover the companies and industry themes that we actually find interesting and that people will actually be interested in reading.”
Short and to the point
New Street Research does not underwrite, trade, or manage securities, and is not in the advisory business either, just research. The research product combines debt and equity analysis, and doesn’t bombard clients with daily, weekly, monthly, quarterly, or annual research.
It only sends out research if there is a meaningful point to be made. Industry research is thematic and company analysis is done within an industry context.
Reports are delivered via the company’s customizable website and are kept to a maximum of 10 pages.
Heading the firm’s fixed-income research effort is Frank Knowles, the former European head of high-yield research at Merrill Lynch. At Merrill, he was the top-ranked telecoms high-yield analyst in the 2001 and 2002 Euromoney credit research polls, as well as the top-ranked high-yield telecoms analyst in the 2002 Institutional Investor survey.
Investment banks still seem to worry about whether investors are willing to pay for the research that they have grown used to receiving. Investors may not be willing to stump up for heavily tainted research but the experience of New Street Research shows that they are willing to pay for something that they consider to be independent and high quality. “A surprisingly large number are prepared to write hard-dollar cheques, perhaps because of all the scrutiny into softing and commission transparency,” says Johnston.
New Street Research tailors its compensation arrangements with all its clients, preferring quarterly hard-dollar billing, but also accepting soft-dollar and commission recapture arrangements.
New Street Research started billing its first paying customers in April this year and has many more currently signed up for its services on a trial basis. It aims to have up to 60 customers eventually and says it is close to that number in terms of those clients currently using its product on a trial basis.
Peter Koh
