Advice From a Master

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New York-Sometimes it helps to look back as we look forward, so we read with interest the ruminations of William Donaldson in the 40th anniversary issue of Institutional Investor magazine.  The interview covers a variety of topics, including Donaldson’s travails at the SEC.  As you would expect from one of the pioneers of modern securities research, Donaldson has much to say about the research business.

Donaldson Lufkin Jenrette was the prototypical research boutique.  Donaldson’s description of DLJ’s approach:  “We did comprehensive research that helped institutions identify and invest in lesser-known, smaller companies at cheaper valuations and improve their performance.”  Note the emphasis on ‘lesser-known, smaller companies’.  DLJ was not a small cap shop per se, but had the freedom to move across market caps.  Donaldson is evoking a time before investment banking captured the research function and harnessed it to its will.  A time when Street research was in fact independent.

The interview with Donaldson was conducted before SEC Chairman Cox called for a ban on soft dollars.  Donaldson predicted greater scrutiny of soft dollars:

“It’s going to be difficult [to get paid] because I think the SEC is paying more attention to how commissions are used to pay for research.  You are going to see much more emphasis put on funds, particularly mutual funds, to justify where those brokerage dollars are going.   There will still be dollars for research, but the firms will have to tell their shareholders how much they’re spending for execution and how much for research.”

Donaldson forecasts greater commission disclosure, with more transparency on how much is being paid for research.   Whether that is the outcome-which it may still be-or whether soft dollars get banned, a tough business is going to get tougher.

In Donaldson’s view, the difficulties in the research business are partly self-inflicted:

“The profitability of the research business was eroding, and that squeezed the firms, but research also squeezed itself by not being research anymore.  There are still some industry experts doing real value-added work, but most of what’s out there today is general and worthless, and no one’s willing to pay for it.”

As commissions spending declines, how much of the decline is attributable to a decreasing appetite for me-too research?  The shuttering of Prudential’s research is a graphic example of the tough environment for research.  Prudential’s research was “independent” but other than a few quality analysts was largely undifferentiated.  It is a warning to all research professionals.

Donaldson’s view is not all gloom.  He holds out hope for research which adds value for investors:

“I still believe that there’s room for quality research.  There’s not a lot of room for 20 or 30 analysts saying what’s going to happen next quarter at big-cap companies.   But there is room for genuine idea generation-research that identifies real changes in business and companies that investors can make money on.”

The research industry is going through a wrenching process of transformation.  The good news is that there is innovation and progress in all aspects of the industry.  New forms of delivery and new tools for managing research and tracking good ideas.  New technologies for extracting investment insights from the web or from large consumer databases.  New types of research giving investors direct access to industry experts or to company management, or to monitor upstream or downstream developments as a way of getting early insight into changing fundamentals for a company.

There is a glut in the type of research that DLJ pioneered, and as Donaldson points out, much of it is mediocre at best.   The oversupply will get corrected as the bundled commissions that DLJ enjoyed disappear either through an outright ban or through greater disclosure.  In the meantime, like a phoenix, the research industry is reinventing itself.   By Donaldson’s standards, many of the innovations may not seem like research at all-except that they provide investment insights.  This is the key and Donaldson said it well.  There will always be a market for idea generation and investment insight.

Comment by Bill George:
Another interesting point about William Donaldson and Donaldson Lufkin Jenrette (DLJ), not long after launching its well respected, high quality independent research business DLJ became one of the early pioneering third-party broker dealers by launching its Autranet brokerage subsidiary.

In compliance with Section 28(e) of the Securities Exchange Act of 1934 DLJ’s Autranet subsidiary offered to pay for independently produced research from institutional clients’ commission dollars “paid-up above the fully-negotiated costs of execution”. Autranet would use these “paid-up” commissions to pay the fully-disclosed price of its sister subsidiary’s (DLJ Research division) research and / or Autranet would pay for other research producer’s independently produced research under the “provided-by clause” of the SEC’s interpretation of Section 28(e). Of course, this whole process was fully disclosed, and the uses of these commission payments were very transparent.

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