New York - In a speech given by Steven Roach August 1st, entitled “Pitfalls in a Post-Bubble World”, Mr. Roach discusses the broad trends in the US consumer sector, housing and international impact of the most recent bubble.

His first point is that the bubble we are currently facing is at least twice the size of the dot-com bubble at the beginning of the decade. The dot-com share of US market cap was 6%, while sub-prime is roughly 14.3% of the US market cap. Adding to the mix is another 12.7% that is in Alt-A product.

News this morning in Bloomberg news highlights a potential $4.0 billion write down in the third quarter for Lehman Brothers. This follows write downs within many of the bulge bracket firms. The  New York Times reports that Lehman is considering selling off some or all of its asset management business to shore up its capital. Other bulge bracket banks, notably Citi, Merrill and UBS are looking at forms of restructuring or selling assets to increase capital.

Lehman has circulated a memorandum of understanding to a number of private equity firms to test their interest in the asset management division. Bidders may isolate the Neuberger Berman asset management firm that Lehman acquired in the 2003 and whose value is posited to be in the $7.0 to $13.0 billion range. The machinations of the bulge bracket reflect a deeper concern about the overall economy.

Steven Roach’s speech steps back for the travails of the Wall Street firms and assess the impact of the bubble on the US economy and the global economy. At its root, the current crisis emerged as the US shifted from consuming out of income to consuming out of asset appreciation. Roach indicates that at its peak, net equity extraction from residential property hit 9.0% of disposable income in mid-2006, from 3% five years earlier. As well, the share of consumption to GDP rose to 72%, from about 66% in the earlier.  The binge eventually resulted in bubbles in the property and credit markets.

Roach also discusses the impact of the entire economy which he characterizes as living beyond its means for decades. The current account has ballooned from 1.5% of GDP in 1995 to 6.0% in 2006. To fund this imbalance, the US has relied on foreign interest in US assets, to the tune of $3.4 billion per day in 2006. Clearly, this is unsustainable, even when the US dollar is the denominator of global trade.

As with all bubbles, the US consumer will need to consume less and revert to a more realistic saving plan to repair damaged balanced sheets.

But is the asset-based consumption limited to the property market? What, if anything, does this mean for the mutual fund world? Were these assets similarly impinged upon?  The answer, according to the Dollar Streacher.com is that about 20% of 401K participants are currently paying back loans on these assets. It seems that the economy and the financial markets are in for a fairly long convalescence.

New York - Soleil Securities Group, an aggregator and distributor of equity research, announced that it has hired a new head of institutional sales.  The announcement follows other recent management changes at Soleil.  StreetBrains, a competing aggregator and distributor of equity research, hired a head of sales earlier this summer.

Soleil announced today that Will McDermott had joined the firm as Head of Institutional Sales.  McDermott joins Soleil from Wachovia Securities where he was head of institutional sales.  Previously he was head of equities for W.R. Hambrecht, where he had also managed institutional sales.

The move follows Soleil’s appointment earlier this month of Vince Farrell as Chief Investment Officer.  Farrell has extensive buy-side experience, most recently with Scotsman Capital Management, a value investor with $200 million in assets under management.  Farrell was previously with Victory Capital Management in Cleveland.

Terry Gardner, who originally joined the Soleil platform as a research provider, was appointed President of the firm in May, transitioning duties from Paul Spillane, the previous CEO of Soleil.  Gardner’s research firm, S-2 Research, provided primary research and due diligence for investors and corporate clients, building on Gardner’s experience as COO of equities at Deutsche Bank.

Meanwhile, StreetBrains, which, like Soleil, is a distributor of research appointed Robert Livingston as Director of Sales in June.  Livingston was previously a VP at BNY Convergex, and a sales producer for Bloomberg Tradebook.

Soleil and StreetBrains are beefing up their sales organizations in parallel with Goldman Sachs Hudson Street platform and Merrill Lynch’s Open Minds platform, which also distribute third party research.  BNY Convergex, meanwhile, eliminated its dedicated Jaywalk sales team earlier this year and assigned Jaywalk sales to its Westminster sales staff.

New York - Value vs. growth is an overused, and often artificial, dichotomy.  Yet there are genuine distinctions in how growth oriented investors utilize research when compared to value investors.

Growth comes in many forms.  The classic definition of growth investing relates to identifying companies whose profits and share price will beat the market over a long period.   Growth investing has broadened to include different types of growth vehicles, including emerging markets and non-equity assets such as racehorses or fine art.

For equities, traditional growth investing focuses on earnings growth, price/earnings and PEG ratios.  Fundamental research, which also focuses on earnings and price/earnings, is a natural fit.  Understanding the consensus is an important component of growth investing, and for this reason proprietary investment banking research is valuable in understanding market expectations and forecasts.

Frustration comes from the over-abundance of fundamental research, compounded by the fact that large cap growth stocks tend be over-followed.  Do we really need over 50 analysts following Google?  Google Analyst Day is a fun outing with lots of free goodies but it is not clear that the hordes of analysts attending are adding much incremental value to the valuation of Google.

The disaffection with conventional fundamental research has prompted a growing number of investors to do their own primary research, sometimes for idea generation, more often for refining potential ideas.  There are a variety of primary research tools available: expert networks, market research, channel checking, data mining, even web scraping (or search-based research as we call it.)    Search-based research is becoming more popular among growth investors as a way to track new trends.  Qualitative-oriented services like FirstRain track buzz in the blogosphere while more quantitative services like InfoSquire scrape data from the web.

The most popular primary research tools are expert networks, which are relatively easy to use and provide fast results.   It is no coincidence that the most popular sectors for expert networks are growth-oriented, namely healthcare and technology.

Growth typically originates either from companies benefiting from technology advances (think Apple) or companies which dominate a niche (think Service Corp International which dominates the funeral home business).  From a research perspective, growth investors place a premium on understanding industry trends.   Sector specialists in growth-oriented industries, such as technology, health care, and biotech are well used by growth investors.

Increasing use is also made of Industry consulting firms which specialize in providing analysis and forecasts of a specific industry-typically sold back into the industry followed.   Often the industry consulting firms are excellent sources for insights on emerging technologies, as well as competitive dynamics, new products, and pricing strategies.

Growth investors use specialist research firms, such as those that analyze intellectual property and patents, to understand the ability of growth companies to create barriers to entry.  Firms that analyze regulatory developments are also popular for understanding whether growth companies are creating regulatory advantages, or whether changes in regulations will impact existing players.

Growth research is one facet in the growth of research.  As growth investors have looked for new ways to analyze and identify growth, new types of research have come to the fore.

New York - Research performance measurement is as much an art as a science. Integrity Research looks at the performance data derived by Investars on a quarterly basis. The table below shows the firms that performed best by looking at the buy and sell recommendations of each firm and assessing the percentage returns in price that accumulated over a 3 year period. The returns are posted in Basis points per day and the top 18 firms are posted.

Integrity includes all coverage sizes in the same analysis, whereas Investars data is divided into three coverage categories-over 500 stocks, between 500 and 100 stocks and below 100 stocks. We have regressed the cross sectional data for returns against coverage and find that the R-Squared is tiny and the slope coefficient of the regression is statistically insignificant. Simply put, there is no statistical linear relationship between coverage and returns. Further the residuals appear to be random, indicating the relationship is not likely to be a non-linear one.

Where we do see a relationship is in the number of recommendations and the nature of those recommendations. For example, the top firm B. Riley & Co generated all of its returns 95.5% return in its sell portfolio. This becomes more incredible when one determines that the RP made only 4 short recommendations over the period. The next firm (Haugen Custom Financial Systems) made nearly 75% of its return from its sell portfolio, but issued 670 sell recommendations.

In fact, only two firms made positive returns on their buy recommendations over the year Haugen and Quidnunc Research. Of note, Quidnunc was able to post a 12.5 basis points per day return, despite not having any sell recommendations included in the calculation.

New York - Recently it has come to our attention that small cap research provider, Sidoti & Company has decided to terminate distributing their research over the Bloomberg system.  Sidoti’s problem isn’t actually with Bloomberg, but rather with another service on the Bloomberg platform, Theflyonthewall.com.  This is not the first time that theflyonthewall.com (the Fly) has provoked feelings of anger in a research provider; Merrill Lynch executive Candace Browning wrote a note on their service in March of last year, and Merrill, Morgan Stanley and Lehman Brothers filed a joint lawsuit against the firm in June of 2007.

The main complaint against the Fly seems to be that they take the intellectual property (i.e. recommendations and ratings) of the research providers and sell them to their clients at a fraction of the cost.  Sidoti is also amazed (and perhaps appalled?) at the speed with which the Fly is able to disseminate Sidoti’s ideas, claiming that the Fly releases Sidoti’s rating changes to their clients before 9:30 in the morning, which is often before Sidoti can contact their own clients with this information.

Of course, Sidoti’s fear is that buy-side clients will value Sidoti’s research less, or they will be willing to pay less for it, because their recommendations are available quite inexpensively over a service like the Fly.  Fly on the other hand feels that all of the information it disseminates is already in the public domain.  They do not get their information from research firms directly but rather from a variety of sources in the industry.  In their view, this method of collection ensures that they are justified in putting out the information that they do.  In the internet age, information is available more quickly than ever before and Fly even has to worry about some of the information they put out being picked up and reproduced in other places.  Candace Browning refers to this trend as well when she discusses the ‘Napsterization’ of the industry in her note.

Sidoti has addressed the issue with both the Fly directly and to Bloomberg and has gotten nowhere in terms of resolving the issue so they decided to pull their research off of the Bloomberg platform.  The reasoning behind this move seems to stem from the fact that Sidoti simply cannot stomach the idea of sharing the same distribution system as a firm that they believe is stealing their research, and in the meantime Sidoti is directing their clients to other platforms such as First Call, Reuters, or TheMarkets.com.  Sidoti does not have the resources to be able to file suit against the Fly as some of the larger sell-side firms did, so instead they feel that an action such as this may inspire others to follow suit.

Sidoti & Company, LLC is a boutique small cap trading and equity research provider with over 50 analysts covering nearly 500 equities across 30 industries.  Companies covered generally have market caps below $3 billion, lack research coverage by the larger brokerage houses on Wall Street, and are profitable. Analysts conduct their own due diligence, visiting companies and talking with the key operating and financial management; the firm will not cover a company unless its analysts have access to the Chief Executive Officer and the Chief Financial Officer. The analysts also check with customers, suppliers and competitors. Overall, Sidoti’s research focuses on fundamentals, particularly on analyzing cash flow from operations.

Sidoti currently has around 500 institutional clients, consisting of asset managers and hedge funds. All of the firm’s clients are from the buy-side. Coverage is initiated with an eight-page report that includes projections of cash flows, balance sheet ratios and quarterly earnings, as well as recommendations. The firm publishes notes and reports when material events occur. All reports include price targets that balance the analysts’ growth expectations for the equities covered against variables such as peer group valuation and historical indicators. Sidoti also hosts annual Investor Forums.

TheFlyonthewall.com describes themselves as a “single source provider of relevant, market -moving financial news, syndicate and event information to equity professionals.”  They deliver an average of over 600 stories a day and claim to use relationships they have with “people ‘in the know’” in order to come up with their information.  They charge $25 for their Fly News service, $25 for their Fly syndicate service, and $15 for their Fly Events service.  One can purchase all services for $50 a month, or for a yearly price of $480.

On March 22^nd 2007, Integrity put out a blog titled Merrill’s New Distribution Policies.  The topic of that blog was a letter that Candace Browning, head of Merrill’s global research, had written in reference to theflyonthewall.com and its policy of redistributing sell-side research almost immediately after its release.  Titled ‘Obituaries for Sell-Side research are premature‘, the note talked of Merrill’s intent to enact stricter distribution policies to thwart a certain website provider who compared its research to “having a seat at Wall Street’s best houses and learning what they know when they know it.”  The note went on to declare that, as the title implies, sell-side research is far from dead and the fact that it is being ‘napsterized’ proves that it still has value.

What the note does not mention is a lawsuit that was filed in June of 2007 by Merrill Lynch, Morgan Stanley and Lehman Brothers against theflyonthewall.com which sought $150,000 in damages for each report infringed.

Sidoti’s recent actions, Merrill’s note and the previous lawsuit all raise the issue of intellectual property.  As of now, Theflyonthewall.com and similar companies such as Briefing.com and streetaccount extract the recommendations that sell-side firms pour billions of dollars into to create in the first place.  The fact that they charge clients a fee for the research that others put out undermines the value of the companies that they take from. Companies such as Sidoti have a harder time finding new clients if their research is available for $25 dollars a month from a different service, and existing clients have a hard time justifying the high cost of the research and insist on paying less.  Sidoti has a cost associated with creating the research it puts out and without income from clients, it will be an impossible task to keep up the research it provides.

These recent developments all point to the rising importance of research providers gaining more concrete control over the distribution of their research.  Without this control it is much easier for them to lose custody over their intellectual property and thus to lose the value that they add to their clients.  As stated above, the way in which the internet effects the dissemination of information cannot be underemphasized.  The big question in exploring this topic now seems to be whether other firms are going to follow the example set by Sidoti and leave the Bloomberg platform.  Whatever the case, the aftermath to this story will no doubt be interesting to follow.

In nature, flies often interact in symbiotic relationships to survive, however if Flyonthewall keeps feeding off of the intellectual property of others, it may come to find that soon there will be nothing left to eat.

New York-Bear markets are a stressful time for most research providers as commissions decline and budgets are cut.  However, there are a few types of research that thrive during market declines, particularly forensic accounting and short ideas providers.  Used to generate sell recommendations, these providers thrive during market turmoil.

In this environment, when bearish analysts like Meredith Whitney of Oppenheimer and Richard Bove of Ladenburg become media stars, sell recommendations become more highly valued.  The forensic research providers have seen this all before…

The forensic sector was a sleepy backwater prior to 2001.  Then came Enron, WorldCom and the rash of other accounting scandals, and suddenly the forensic sector was hot.  David Tice of Behind the Numbers was appearing on Louis Rukeyser, Mark Roberts of Off Wall Street was testifying at Congressional hearings, and Howard Schilit of the Center for Financial Research and Analytics (CFRA) was a fixture on CNBC.  More importantly, nearly all their recommendations made money as the markets continued to tank through 2002.  Times were suddenly very good for the original pioneers of the space.

Then two things happened.  The markets started recovering in 2003 and a horde of new competitors entered the space.  The number of research providers more than tripled, from 6 to 19.  Suddenly, the market was not so congenial.  In fact, business began to contract, as new clients who had rushed in at the tail end of the market decline suddenly lost their appetite for short ideas as the markets were rallying 20-30% per year.  Investors began to get complacent, arguing that Sarbanes-Oxley would fix the problems that spawned Enron.  Roberts hunkered down and launched a long oriented product in 2003.  David Tice began turning more of his attention to money management and sold his research operation to employees in 2007.  Howard Schilit, with impeccable timing, sold his business to a private equity firm in 2003, which in turn sold the business to Riskmetrics in 2007.

Now, business is booming again.  Short ideas are in demand, and are providing good returns for investors.  Forensic research providers, having survived previous boom/bust cycles, are less likely to be whipsawed this time around.

New York – An article in the New York Times this morning entitled “Analyzing Wall Street’s Research” discusses comments made by Frank Quattrone at a recent conference. In short, Quattrone suggests that the Spitzer settlement be repealed. The settlement, among other things, prohibited analysts from receiving payment from any investment banking activity. This means that the research must be paid through the execution window of the trading desks.

Quattrone’s logic is that the forces that are exerted on the sell-side research shops by the settlement serve only to reduce the quality of the research—as senior analysts move to the buy-side—and to reduce the coverage of the sell-side shops—as they move into more lucrative and liquid stocks. His point—which is not lost on many in the field—is that small cap research will suffer, leading to less investment in these firms, less innovation and ultimately a less competitive US financial system and economy. Indeed, we have seen the volume of IPOs launched in the US falling and those launched in London and Hong Kong rising.

Quattrone suggests that conflicts still exist and that better disclosure be required to offset the removal of the settlement. While we agree that conflicts still exist and that the small cap sector is getting beat up, we do not see how allowing the research departments to be paid by investment banking groups can possibly be a progressive move in the management of conflicts in the research industry.

 One stark irony of today’s markets is that the Spitzer settlement was put in place essentially to ensure that Wall Street analysts did not issue overly optimistic research to help woo investment banking business. Recently, the SEC has had to enforce new rules on shorts, to ensure that the Wall Street analysts are not too pessimistic on share prices.

New York, NY - In the past, a number of Wall Street analysts have cried foul, saying that their company’s management tried to get them to raise their stock ratings, fearing that the negative research would hurt other parts of the firm’s business.

In fact, Merrill Lynch was recently accused of just such a maneuver regarding a negative report published by their credit research department on Auction Rate Securities.  However, independent research firm, Morningstar, was recently accused of “strong arming” research analysts to change their opinion on various stocks - by lowering what research management thought were overly optimistic ratings.

According to a Wall Street Journal article published on July 26^th, one former Morningstar banking analyst, Ganesh Rameshrathinam, accused executives at the company of pressuring him and other analysts to lower their ratings on some financial stocks earlier this year - a practice that Mr. Rameshrathinam claims was common “even if there was no reasonable basis for the request.”  Morningstar management denied any wrongdoing.

Part of the problem sprung from the fact that Morningstar has traditionally tried to focus its research on the long-term value of companies, making a “fair value” estimate of what they think the shares should be worth.

Unfortunately, Morningstar’s analytical approach didn’t work well when applied to the volatility seen in the financial sector over the past year and a half.  For example, Morningstar’s banking analysts held extremely bullish views on companies like Countrywide or Citibank, even as these firms were caught up in the midst of the credit crisis.

However, Mr. Rameshrathinam, and his manager at the time Rachel Bernard, said that Morningstar management were not comfortable with their ratings.  Ms. Bernard says that she was told to make her “fair value” estimate for Countrywide more in-line with what the market was saying, versus the much more optimistic views her model was coming up with.  Mr. Rameshrathinam says that management also asked him to lower his estimates for Citigroup.

Morningstar management counters these accusations by saying that the turmoil in the markets resulted in a vigorous debate at the firm about the validity of their research process.  And while they deny they ever “strong armed” their analysts to change their recommendations, the firm’s management did say that Mr. Rameshrathinam was unwilling to consider the signs that Citigroup would post huge losses - a development that would require the firm to raise huge amounts of capital, thereby pushing the price of the stock lower.  Of course, this eventually took place.

Company officials also explain that Mr. Rameshrathinam, who left the firm at the end of June, demanded that Morningstar pay him to keep from going to the press with his accusations.  Mr.  Rameshrathinam denied this as “a blatant lie.”  Morningstar has acknowledged that they hired a law firm to investigate Mr. Rameshrathinam’s complaints.  They explained that the law firm found no violations of the company’s code of ethics.

It is interesting to note that earlier this year, Morningstar issued new analyst guidelines to include the impact that short-term developments might have on the long-term value of a company and its stock.

Our Take

It is a little surprising to the team at Integrity that Mr. Rameshrathinam’s accusations have gotten as much publicity as they seem to have received.  It is clear that Morningstar’s concerns about their banking analysts’ optimistic recommendations did not reflect conflicts of interest, but rather a vigorous internal dialogue about the problems their existing research process was having to assess the value of financial services companies.  Unfortunately, Mr. Rameshrathinam felt that Morningstar had no right to question his recommendations, even if market conditions suggested that his (and the company’s) analytical process was flawed.

New York, NY - In the past few years, the aggressive promotion and increased use of Commission Sharing Agreements and Client Commission Arrangements in the US has led directly to increased concentration of equity trading, as institutional clients have reduced the number of execution partners they do business with.  Consequently, many larger trading firms have gained market share at the expense of the smaller regional firms.  However, this consolidation is not just taking place with institutional equity clients.  In fact, a similar shift is being seen at regional broker-dealers as retail clients migrate either to the big wirehouses or to the growing number of independent brokers.  As a result, many of these firms are simultaneously fighting a migration of both institutional trading revenue and retail brokerage commissions - a one two punch that is leaving many regional brokerage firms reeling.

New York - US investors do not seem to be as concerned with ESG issues as their European peers. Not surprisingly, the demand for ESG research in the US is still lagging behind Europe. Integrity has been analyzing some interesting trends in ESG research in the US and abroad.

The last few years have witnessed increasing concerns related to environmental, social, and governance (ESG) issues at different levels - even among institutional investors. According to SocialFunds - a finance site devoted to analyzing topics related to socially responsible investing -  ESG funds, governmental initiatives, and corporate measures have proliferated worldwide in the last decade. The site contains multiple examples of banks, funds, and corporations around the world that have aligned their efforts and resources with ESG issues (e.g. Fuji, Glass, Lewis & Co., and TD Asset Management, among others).

In addition to the measurable increase in ESG-oriented businesses, there are other indicators that suggest the prominence of ESG issues in the investment arena.  One of these indicators is the development of the United Nations’ Principles for Responsible Investment (PRI). A survey conducted among the signatories to the Principles reveals a higher integration of ESG issues within investment practices. The surveyed signatories revealed that they are increasingly engaging in practices such as revisiting relationships with service providers, interacting with policy makers, and tightening their reporting practices to include ESG issues, among others. Furthermore, the number of signatories to the Principles has more than doubled in 2008 to 381 parties, which represent US $14 Trillion in assets under management.

Despite the enthusiasm surrounding a perceived increase in ESG measures at the corporate level, we at Integrity have not witnessed a corresponding impact on the use of ESG research, particularly in the US. Our database reveals that the formation of ESG research providers worldwide has dramatically decreased in the last two years in comparison to the boom of ESG research firms in the first five years of the 21^st century. The following chart illustrates this phenomenon:

Number of ESG Research Firms Founded, by Year

Source: Integrity Research

Taking a closer look at the number of ESG research providers in each region we noticed that the US is lagging behind Europe in the number and variety of ESG providers. Combining US and Canada, our database includes 18 providers (of which, a large percentage are specialists in corporate governance). Comparably, Western Europe includes 23 providers, including an institutionalized network of providers that unite their efforts in order to provide comprehensive and unique ESG research.

The ESG research space in the US includes unique and reliable providers, but we have not witnessed a significant increase in the number of firms. Conversely, European countries seem to be dedicating efforts to improve their already robust ESG research space.

ESG Firms by Region

Source: Integrity Research

The slow increase of ESG research providers in the US may be a result of a low demand. One might think that American investors do not see a direct link between stock performances and ESG issues. Having its roots in the early 1800’s as a religious initiative, and now institutionalized as intergovernmental initiatives (i.e. PRI), ESG have found opposition in some people who argue that ethical motivations might be financially unsustainable, therefore they should not guide investment decisions.

Integrity Research will continue to dig deep into this issue. Our goal is to uncover American and European investors’ real perceptions regarding ESG research.