Research Renegades

Fed up with conflicts at big banks, equity analysts are striking out on their own and winning over jaded investors. Not all of the fledgling firms will make it.

By Edward Robinson
Bloomberg Markets, November 2009

When Credit Suisse Group analyst Ivy Zelman refused to turn bullish on homebuilding stocks during a rally in the fourth quarter of 2006, the blowback was intense.

She says investors told her that some housing industry executives were ridiculing her analysis as a “jihad,” and several of the bank’s sales representatives pressed her to upgrade “hold” ratings to “buys” on companies to appease bullish institutional-investor clients. One sales manager even sent her an e-mail warning that analysts who stayed bearish too long often lost their jobs.

Zelman was furious. She’d spent 16 years dissecting the home construction business and wasn’t about to ditch her analysis and join the bulls’ party. On Dec. 7, 2006, she slapped a “sell” call on the entire group, and during the next 12 months, the Standard & Poor’s Supercomposite Homebuilding Index plunged 53 percent as the real estate market collapsed.

Stefano Natella, Credit Suisse’s global head of equity research, says that while debate between the sales team and research staff over their calls is normal and healthy, the e- mail from the manager crossed the line and he was reprimanded. Even though Zelman had Natella’s support, she grew fed up with a culture that prized irrational exuberance over sober analysis.

“It was no fun being the bear,” Zelman, 43, says. “I’d come home from work and just be so upset. So I started thinking, ‘If I believe in my work, why not do it on my own?’”

Going Solo

In May 2007, she resigned from Credit Suisse. After weighing whether to start a hedge fund, a buyout boutique or a research firm, she settled on the latter and opened Zelman & Associates, in Cleveland and New York, five months later.

Zelman is one of a rising number of equity analysts who’ve quit large banks and gone solo. They’re joining a wave of investment bankers and traders who’ve moved off Wall Street to set up mergers and acquisitions advisory firms and work at mid- size brokerages as the financial world reconstitutes after the credit crackup.

Independent research firms are popping up in New York, Silicon Valley and London, where Stuart Graham, the former head of Merrill Lynch & Co.’s European banking stocks team, unveiled Autonomous Research LLP in July with the motto “Free from external control and constraint.” The number of independent research firms in the U.S. has soared to 2,667 from 1,012 in 2006, according to Integrity Research Associates LLC., a New York-based consulting firm.

Outflanking Wall Street

Zelman and her fellow independents are taking aim at Wall Street banks by selling research to institutional investors, ranging from PNC Capital Advisors Inc., an investment firm in Philadelphia, to hedge fund firms such as Passport Capital LLC in San Francisco and Vardon Capital Management LLC in New York.

Independent shops will have a hard time outflanking resurgent securities firms, which possess huge advantages. Their underwriting and allocation of equity offerings motivates money managers to preserve their relationships with brokerages, says Jay Bennett, a consultant with Greenwich Associates, a Stamford, Connecticut-based firm that advises institutional investors.

Today, Bank of America Corp., JPMorgan Chase & Co. and other giant securities firms receive almost 70 percent of the commissions institutional investors dole out for research. That compares with 3 percent for independents and the rest for mid- size firms, according to Greenwich.

“There is a symbiotic relationship between the bulge- bracket bank and the typical institutional investor, and I can’t see that being displaced,” Bennett says.

Analysts Marginalized

In 2002, then-New York Attorney General Eliot Spitzer and the Securities and Exchange Commission began investigating the research industry in the midst of conflict of interest scandals that erupted after the dot-com bubble imploded in 2000. Rock star analysts like Jack Grubman, the telecom specialist at Citigroup Inc. who earned $67 million from 1999 to 2002, and Henry Blodget, Merrill Lynch’s dot-com guru, had issued glowing recommendations of companies to win investment banking business, according to lawsuits filed by the SEC.

In 2003, the SEC prohibited the analysts for life from associating with a broker-dealer or investment adviser. Grubman and Blodget didn’t admit or deny wrongdoing in their settlements.

In 2003, Spitzer and the SEC struck a settlement with Goldman Sachs Group Inc., Merrill and eight other major banks that permanently barred them from using investment banking revenue to compensate research staffs and fund their work. Analysts became marginalized on Wall Street, losing thousands of jobs and their seven-figure salaries: Annual pay for top performers fell to about $600,000 by 2008 from a peak of $2.5 million in 2000, says Alan Johnson, president of Johnson Associates Inc., a New York-based compensation consultant.

Curbing Excesses

“The analysts that were good stock pickers all went to hedge funds,” says Steven Purvis, a money manager at Fort Worth, Texas-based Luther King Capital Management Inc., which oversees $6 billion.

The settlement did curb many of the excesses of the Internet era, says Robert Olstein, chairman of Olstein Capital Management LP, a mutual fund firm in Purchase, New York. Money managers continue to plumb Wall Street research for valuable information on companies and markets their own internal analysts may lack, says A. Michael Lipper, a director at the New York Society of Security Analysts, a professional organization.

Rare ‘Sell’ Calls

In the fourth quarter of 2008, Betsy Graseck at Morgan Stanley recommended investors sell shares in Bank of America after concluding its credit card business and takeover of Countrywide Financial Corp. would saddle it with huge losses. Nineteen of the 21 analysts who covered Bank of America at that time had “buy” and “hold” calls on its stock, which nose- dived 80 percent from Sept. 30, 2008, to March 31, according to data compiled by Bloomberg.

“Some money managers may deride the research, but I know demand for it at institutions is high,” says Lipper, the founder of Lipper Advisory Services Inc., a Summit, New Jersey- based firm that consults for foundations and pension funds.

Calls like Graseck’s are not common in a Wall Street research system that continues to promote rampant bullishness, according to studies by Jill Fisch, a business law professor at the University of Pennsylvania in Philadelphia. In October 2008, as the global financial system teetered on the brink of collapse, “sell” calls in U.S. markets constituted 6 percent of the total recommendations by analysts, with “buys” comprising 36 percent and “holds,” 58 percent, according to Bloomberg data.

‘Conflict-Free Research’

Almost a year later, amid a stock market rally, the percentage of “buy” calls dropped: They made up 32 percent, with “holds” comprising 63 percent and “sells,” 5 percent, as of Oct. 8.

Money managers are concerned that proprietary trading desks at the largest securities firms are benefiting from research reports at the expense of clients. On Aug. 25, William Galvin, Massachusetts’s top financial regulator, subpoenaed Goldman Sachs for information on possible weekly “trading huddles” between its analysts, traders and investors.

Galvin wants to know whether Goldman’s analysts previewed imminent changes in their stock recommendations for select clients and whether Goldman traded on these tips for its own account before disseminating the information.

“We don’t like hearing stories about possible front- running or preferential treatment of some clients over others,” says Jonathan Boersma, director of practice standards at the CFA Centre for Financial Market Integrity in Charlottesville, Virginia. “Investors want conflict-free research.”

Break From the Pack

Goldman spokesman Ed Canaday says the bank doesn’t comment on regulatory matters. Authorities haven’t accused Goldman of wrongdoing.

Independent analysts are trying to win clients with calls that break from the pack. In January, Dana Telsey, founder of Telsey Advisory Group in New York and the former head of retail, apparel and luxury goods research at Bear Stearns & Co., made J. Crew Group Inc. a top pick for the year. Telsey was one of 3 analysts out of 20 who cover the New York-based retailer to favor the stock at that time. By Oct 8, it had skyrocketed 208 percent.

On March 23, Keith McCullough, founder and chief executive officer of Research Edge LLC in New Haven, Connecticut, urged clients to buy San Rafael, California-based software maker Autodesk Inc. Only 4 of the 17 analysts who cover Autodesk had “buys” on the shares, which spiked 64 percent through Oct. 8.

Independents Misfire

“Independent research is much cleaner,” says Douglas Famigletti, a money manager at New York-based Griffin Asset Management Inc., which oversees $415 million. “They aren’t conflicted, and they can write whatever they want about a stock. Of course, that means nothing if their ideas aren’t any good.”

The independents do misfire. On April 8, Zelman downgraded D.R. Horton Inc., a Fort Worth-based homebuilder, to “sell” after seeing it trade at 1.60 times its adjusted book value compared with the industry’s median valuation of 1.32. D.R. Horton rallied 18 percent through Oct. 8 on renewed momentum in homebuilding stocks.

And McCullough, a macroeconomic analyst who covers stocks, commodities and emerging markets, got stung in May by advising investors to short the India Fund, which includes equities traded on the Bombay Stock Exchange. The ruling Congress Party’s landslide victory in elections that concluded on May 13 triggered a 43 percent surge in the fund’s shares that month. In a short sale, an investor borrows and sells a security in the hope its price will drop before he has to buy it back.

Main Street Left Behind

Hedge funds are spurring much of the demand for independent research, says Sanford Bragg, president of Integrity Research Associates. After a record 1,471 hedge funds closed in 2008, the survivors in the $1.4 trillion industry are under pressure to deliver gains to their clients, and that’s stoking demand for innovative analysis.

“There is a flourishing alternative research marketplace, but it’s driven by hedge funds,” Bragg says. “It’s invisible to retail investors.”

Main street is being left behind. The Spitzer settlement tried to spur an independent research industry for retail investors by requiring the 10 participating banks to spend a total of $432.5 million on alternative analysis and offer it to their clients for free. In the next six years, Bragg says, the banks found very few takers for the independent research because most investors continued to trust their brokers or didn’t know it was available.

No Exclusivity

“It’s hard to argue the settlement had any lasting impact,” Bragg says.

Independent research appeals to hedge funds partly because of its limited distribution. Stock research is widely disseminated through e-mails, Web sites and published reports. Gabe Birdsall, a portfolio manager at Brasada Capital Management, a Houston hedge fund firm, says he’s inundated with more than 400 e-mails a day, much of it securities reports.

“The problem with research is everybody is getting the same stuff; there’s no exclusivity,” says Penny Herscher, CEO of FirstRain Inc., a San Mateo, California-based company that developed a search engine hedge fund managers use to prowl the Web for obscure market and company data. “There is enormous interest at hedge funds to control their own information.”

Exclusivity doesn’t come cheap. Many independent firms have about 100 clients and charge them $15,000 to more than $100,000 a year. They receive a basic subscription to reports and newsletters, and for additional fees, clients get the right to talk to analysts one-on-one and attend conferences where they can meet with company executives.

Shrinking Industry

In September, Zelman hosted a three-day conference at the Four Seasons Resort & Club near Dallas where about 350 guests including clients tried to glean insights from the CEOs of KB Home, Pulte Homes Inc. and others.

The proliferation of research firms in the past few years will make it harder for them to survive, says Scott Cleland, a former telecommunications analyst who closed his own firm in 2005 after concluding he was in a shrinking industry. Cleland says there’s an oversupply of analysis, which is bound to push down the prices the independents can charge. On Oct. 6, Integrity Research reported that 11 independent firms had disbanded in recent months.

“If the independents analyze their own business the way they analyze the industries they cover, they’ll conclude what I did: The business is increasingly not viable,” says Cleland, who now runs a Washington-based telecom consulting firm called Precursor LLC.

‘Control My Own Destiny’

Many independent analysts are happy to swap the market power of their former employers for their newfound freedom. Edward Wolfe, who built Bear Stearns’s transportation research team, became exasperated with how disastrous decisions made by colleagues in other parts of the firm hurt his group. In late 2007, Bear’s massive losses on subprime mortgages drove its shares from a high of $171.51 in January 2007 to $4.81 in March 2008, obliterating the deferred compensation that accounted for up to 50 percent of Wolfe’s pay.

“Our team was having a great year, but because of issues in mortgages, our compensation was impacted, and that really got to me,” Wolfe says. “I want to be in control of my own destiny and the revenue I generate.” After JPMorgan absorbed Bear in March 2008, he quit and opened his own firm, Wolfe Research LLC, in New York one month later.

Zelman, the credit Suisse analyst, had little idea how difficult running her own shop would be. There are clients to advise, new customers to win and a never-ending stream of research to distribute.

A Frenetic Pace

While she’s delegated some chores -- President David Zelman, her husband, manages day-to-day activities and client relations, and Director of Research Dennis McGill, a former Credit Suisse colleague who helped Zelman set up her firm, oversees the analysis process -- Ivy is still preoccupied with making sure all the parts of her 15-employee company perform.

“You worry about the client that’s not paying you and the salespeople who may not be doing their jobs, and at Credit Suisse, you didn’t have to worry about that,” she says. “You underestimate how much of your personal life you have to give up.”

Ivy and David, 46, a former Salomon Brothers Inc. institutional salesman, share an office suite in a three-story corporate park in suburban Cleveland. It’s decorated with their youngest child’s finger paintings, and sometimes their three kids, ages 4 to 9, visit after school.

Even in Cleveland, where the couple moved to be closer to David’s family, Ivy retains a New York look -- black blouse and black slacks -- and a frenetic pace. Phones are ringing nonstop on July 28 as Zelman analyzes just-released data: New-home sales in June jumped the most in eight years, and property values look to be stabilizing.

Mounting Foreclosures

Many of her clients are clamoring to know whether the market has hit bottom. In terms of prices, she says probably not: One out of three owners has a mortgage worth more than the value of the home, and mounting foreclosures and distressed properties are slated to account for 53 percent of home sales in 2010 compared with 40 percent in 2008, according to Moody’s.

“When that inventory hits the market, it’s going to undermine prices,” she says.

Zelman eyeballs the shares of Masco Corp., a Taylor, Michigan-based manufacturer of home improvement products, and sees they’ve jumped 8 percent off their opening price of $12.13.

“If anyone asks, just say we think the stock has gotten a little ahead of itself,” Ivy calls across the room to David. He nods, phone in hand, and passes the word to a client.

Private Network

Zelman relies on her own network of almost 1,000 private homebuilders, mortgage bankers and even drywall distributors to provide intelligence about the housing market. Under a barter arrangement, the contacts agree not to talk to other analysts in exchange for her research.

Every month, Zelman surveys her sources, asking about demand for their products and the forces spurring or curbing it. The data form the basis of her analysis, and encrypted reports are available to clients on her Web site.

Hedge fund managers use Zelman’s reports to see where the housing market may be headed and as a check on months-old housing data that drive investor assumptions. As early as July 2005, she alerted clients to the coming mortgage crash in a report called “Investors Gone Wild.”

“You’re going to find out what’s going on from her network long before you get it from the sell-side and publicly released data,” says Ryan Randall, an analyst at Passport Capital, a Zelman client and $2.1 billion hedge fund firm.

Premature Rally

Investors buoyed by positive housing data bid up the S&P homebuilding index 43 percent from June 30 to Aug. 28. Zelman learned from her network that the $8,000 federal tax credit for first-time home buyers passed in President Barack Obama’s stimulus package was fueling demand and speculative construction. And as banks continue to disgorge foreclosed properties into the marketplace, a supply glut could wallop homebuilding stocks yet again.

“The rally may be premature,” she says.

So on July 13, Zelman advised clients to exploit the short- term jumps in some homebuilding stocks while recognizing that the surge might end soon. She upgraded M/I Homes Inc., a Columbus, Ohio-based homebuilder, to a “buy,” and shares rose 55 percent to $13.13 during the next 14 trading days. Zelman cut M/I Homes to “hold” on July 31 after it hit her price target. The stock climbed another 12 percent by Oct. 8

“Ivy’s a little too bearish on our industry right now,” says Robert Schottenstein, M/I Homes’ CEO. “But she understands what it takes to make money in this business, and I have a great deal of respect for her.”

Rapidly Expanding

Zelman, who put herself through night school at George Mason University in Virginia and earned a bachelor’s degree in accounting, plans to push her firm beyond the 20 homebuilding stocks she covers to draw new clients.

She will initiate coverage of Home Depot Inc. and Lowe’s Cos. by the end of the year. Zelman says her firm makes a profit, and true to form, she’s cautious about overreaching.

“I don’t want to be in a situation where I hire five analysts and all of sudden they’re making calls I disagree with,” she says. “There’s no rush.”

By contrast, Telsey, the retail analyst from Bear Stearns, is rapidly expanding the firm she opened in February 2006 on Fifth Avenue, New York’s luxury apparel mecca. Its 46 employees occupy a hive of glass-walled offices with polished-stone floors. In a bullpen of cubicles, a half dozen analysts scrutinize stocks in nine consumer-related industries for clients, including PNC Capital Advisors.

‘Market Share Counts’

Telsey, 46, in a corner office cluttered with black shopping bags from Barneys New York and stacks of financial reports, says she’s hiring analysts and pushing coverage into cosmetics, footwear makers and drugstores.

“Market share counts,” Telsey says. “We didn’t get into this venture to be small.”

Telsey, a Manhattan native with a Master of Business Administration from Fordham University, joined Bear in 1994. Twelve years later, she was running its 18-member retail research team. She grew frustrated at her inability to promote her people and award bonuses -- decisions made by management committees -- and watched as rivals, especially hedge funds, raided her ranks.

“The bulge brackets provide an entry point for people to get into the research business, but they weren’t making careers there anymore,” Telsey says. “I wanted to do my own thing where analysts could practice the craft of research as a career.”

Tough First Year

The first year was rough, says Arnold Kanarick, Telsey Advisory’s executive vice president and Bear’s former human resources head. About two-thirds of the money managers they solicited balked out of concern Telsey’s work would falter and she would lose access to CEOs. She had to invest more than $1 million of her own capital in a sales staff and analysts in the hope business would come.

“Some independents will not be successful because they’re undercapitalized, and clients will hesitate to sign up because they’re not sure they’re going to survive,” Kanarick says. “We say that with the voice of experience.”

Telsey, who favors black Italian pantsuits and Prada pumps, plowed ahead with her research. She tours malls across the country to see how merchandise is selling at the companies she covers and which stores are staging their wares creatively to boost sales.

“Retail is entertainment,” says Telsey on Aug. 31 over the pulsating club music in an American Eagle Outfitters Inc. clothing store in San Francisco. She flashes a smile at the salesclerks and peppers them with questions.

Top Pick

“Are you working more hours or less in the last month?” Telsey asks a clerk.

“Last week, we all had a lot of hours,” the clerk replies. Sales are probably up at this store, Telsey says.

Her shoe-leather research paid off this year, helping her select Gap Inc. as a “top pick” for 2009 in an outlook she sent clients in January. Telsey doesn’t issue “buys” or “sells,” preferring to set price targets because that’s how money managers select stocks.

She said the San Francisco-based retailer’s struggle to rebound from years of falling sales had left it with $1.6 billion in cash, no long-term debt and a winning back-to-basics lineup of jeans, plaid shirts and chinos. Gap shares soared 69 percent through Oct. 8.

Flashing Green Orbs

In the same outlook, Telsey missed on Wal-Mart Stores Inc. She predicted the stock, which returned 18 percent in 2008, would continue its run in the first half of 2009 as the retailer pulled cost-conscious consumers from Target Stores Inc. Instead, investors pulled back in anticipation that the economy would recover and Walmart’s shares fell 15 percent by June 30.

“Walmart was last year’s stock,” she says.

Telsey says she’s turning a profit, winning over about a third of the institutional investors that were reluctant to hire her in 2006.

“There are still a lot of good analysts at the bulge brackets, so it comes down to what are you doing that’s going to differentiate you from your competitors,” Telsey says.

When McCullough, the macroeconomic analyst, formed Research Edge in April 2008, he was intent on upending the way analysis is delivered to investors. His pitch to clients is transparency.

McCullough, a former hedge fund manager at Carlyle Group, makes pretend bets based on his team’s stock recommendations, and clients can view the outcome of each one of his 650 phantom investments on the Research Edge Web site. He places flashing green orbs next to tickers he’s buying and red lights by stocks he’s shorting. By running his firm like a virtual hedge fund, he shows clients how his analysis performs.

‘Show Wins and Losses’

“The research game is broken,” McCullough, 34, says. “We’re just showing our clients what they normally don’t see. If you want to be in the game, you have to show your wins and losses.”

On Sept. 16, McCullough put Apple Inc.’s ticker on the site with a red light. He advised clients to short the tech juggernaut at $182.55 a share, a 52-week high, after Jim Cramer, the CNBC investing personality, recommended it.

“Cramer was pumping it last night,” McCullough wrote in a note.

He believed the commentator was wrong and Apple would fall. On Sept. 21, the analyst covered his short bet on Apple at $182.30 for a 0.14 percent return.

“It’s nice to be able to go back and see if his analysis has panned out,” says Birdsall of Brasada Capital Management, a $50 million hedge fund firm founded in January.

A Trader’s Metabolism

Research Edge’s seven analysts work in the former mansion of William Howard Taft, the U.S. president from 1909 to 1913, on the edge of the Yale University campus. They cover a hodgepodge of industries: Rebecca Runkle, a former Morgan Stanley technology analyst, researches software and computers, and Brian McGough, another Morgan Stanley alum, analyzes apparel and footwear. Their colleagues study health care, casinos and gaming, and emerging markets.

McCullough, with an undergraduate degree in economics from Yale, says his firm is profitable. He has more than 100 institutional clients who pay $30,000 to $100,000 a year for his firm’s research and access to its analysts. Individual investors who want to see the virtual portfolio and a limited amount of research pay $400 a month.

McCullough, a native of Thunder Bay, Ontario, and former captain of the Yale varsity hockey team, has the metabolism and gung-ho nature of a trader.

“I had the most penalty minutes on the team in my sophomore year,” says McCullough, who had to replace two of his front teeth after they were knocked out on the ice.

China Correction

He gets up almost every morning at 4 a.m. to review the Asian markets. At 8:30 a.m. on July 21, wearing a pullover fleece and jeans, he convenes a daily morning conference call with clients. McCullough and Andrew Barber, his Asia expert, predict that Chinese equities, which had soared almost 76 percent during 2009, are headed for a correction.

One key reason: Short-term interest rates in Shanghai shot to 2.13 percent on July 21 from 1.21 percent on July 1 and pressed investors to liquidate holdings to meet margin calls. The Shanghai Stock Exchange Composite Index fell 16 percent from July 21 to Sept. 1.

“He’s pretty freewheeling in his opinions, but he’s a very good macro strategist, and he’s made great calls in this market,” says Ralph Reynolds, McCullough’s ex-boss at Carlyle and now co-founder of Bienville Capital Management LLC, a New York hedge fund firm.

‘In It to be Right’

McCullough jumped into analysis after managing long and short positions in consumer stocks as part of Carlyle’s $900 million Blue Wave hedge fund, which was launched in March 2007. By the third quarter of that year, the fund had dropped 9.3 percent mainly due to wrong-way bets on mortgages that didn’t involve McCullough. His stock portfolio was also declining in value, and that November, he and his six-member team were fired, he says.

McCullough, peeved by the episode, invested more than $1 million of his own wealth to form Research Edge and challenge the big banks’ research machine.

“I wanted to show Wall Street what the best investment research process is,” he says. “I’m not in this to generate trade flow or a banking deal. I’m in it to be right. I want to build something that will last.”

McCullough and his fellow independents have a long way to go before they can shake loose the big banks’ domination of the research game. If they make good calls, they may survive and even thrive.

“There will always be an opportunity for those who can make other people money,” Luther King’s Purvis says.

That’s the one unshakable truth on Wall Street.

Edward Robinson is a senior writer at Bloomberg News in San Francisco, edrobinson@bloomberg.net

		Email this article Printer friendly format