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Aug 31, 2002

In the belly of the whale

Inside the world's largest institutional investors there are schools of analysts

If you think the typical buy-side analyst is a generalist who covers hundreds of companies in dozens of industry sectors and gets company-specific information mainly from sell-side research, think again. Large institutions are steadily building their research departments and generating ever more analysis under their own roofs. The result is a new breed of buy-side analyst with just as much information about your company as anyone on the sell side.

Consider that by some current estimates, Putnam and Fidelity each have more analysts under their roofs than Merrill Lynch. Looking at the ten largest institutions, Greenwich Associates notes the average number of US buy-side equity analysts rose from 25.7 in 2000 to 28.8 in 2001. During the same period the overall buy-side industry average rose by a comparable proportion. And these statistics only refer to US analysts covering US equities. When you factor in the full spectrum of financial analysts and geographical regions, the amount of analysts on the buy side skyrockets.

Greenwich also confirms that the number of industry groups the average buy-side analyst follows has dropped in the past year from 5.3 to 4.6. At the same time the average number of times the same analyst contacted a company rose from 8.2 to 11.2. In short, each buy-side analyst is focusing on fewer sectors and speaking with company management more often. This is the new paradigm of institutional research. The days when the sell side was the conduit through which public companies and institutions communicated are gone.

'The stats point to the fact that institutions are having to dig for incremental amounts of primary information,' says Melissa De Vries at Greenwich Associates. 'The buy-side analysts are needing to spend more time contacting company management and they are probably doing more fundamental research in-house as well.'

Paradigm shift

What is causing this paradigm shift? According to Andrew Reid, Multex's VP of strategic development, mutual fund complexes are dramatically increasing in size and scale, and they are consolidating funds within their fund families. 'What this means in practice is that there are fewer portfolio managers. Therefore the institutions can actually readjust their assets internally towards a more support-oriented organization and leverage their technology across a larger group,' he observes.

Another reason, according to Valuation Technologies' president, John Lewis, is the questionable value of sell-side research. The conflict of interest between Wall Street institutions' research and investment banking operations is now common knowledge. Meanwhile regulators continue to expose instances of sell-side analysts maintaining their buy recommendations on companies even as those companies implode. 'With all of the publicity on conflict of interest, it's inevitable that the buy side puts more focus on its own research and less on the sell side,' Lewis concedes.

First Call's director of research and chief financial analyst, Chuck Hill, says the deeper issue is not the objectivity or integrity of the sell-side research, but the time spent on it. 'It's easy to say the analysts are conflicted because they're getting compensated by investment banking, but I think the bigger problem is that they spend too much of their time chasing deals and not enough time out doing good fundamental research. So, as a result, the quality of the research isn't as good as it should be.' Buy-side analysts, because they are less involved in salesmanship, have the luxury of spending more of their time on fundamental research. Also, they are in a better position to work candidly with their portfolio managers because their interests are aligned. As Hill surmises, 'If I'm only going to have one opinion to listen to, I might as well have it in-house.'

A third element that is fertilizing the growth of buy-side research is budgetary restriction. Whereas mutual funds traditionally paid for Wall Street brokerage research with soft dollars - commission fees generated by trades routed through brokerages - trading execution provided by sell-side firms is now relatively costly. Budget-minded institutions have come to redirect sizable trading volume through cheaper alternative trading systems, and therefore they have been paying for less research with soft dollars.

Greenwich Associates' studies show that institutions are generally cutting back their trading costs and decreasing the number of sell-side firms they use for research. In the past year, for instance, the largest ten institutions have gone from using 15 brokerages on average to fewer than 13.

Best things in life

'One of the beauties of Wall Street research is that it is free, but you cannot soft-dollar internal research expenses,' claims Jim Delisle, an analyst at Independent Perspectives, a Boston-based research boutique. 'This is a situation where the institutions have to think long and hard before they internalize any research because they're not going to be able to soft-dollar that expense any more.' And yet the trend toward internalization continues, suggesting institutions believe it is a good investment.

Since these costs are all out-of-pocket, the process of internalizing research may offer advantages to larger institutions with deep pockets. Delisle explains: 'Traditionally Wall Street research was an equalizing function that gave the little guys as much chance as the big guys. Now if we're going back to a world where no-one pays any attention to Wall Street research and everyone has to eat their own cooking, it strongly advantages the big guys.' He says the competitive landscape is beginning to look like that of the mid-1980s, 'where you could actually differentiate yourself from the other guys based on your internal research process.'

Benjamin Chui concurs. As managing director of San Francisco-based American Pegasus Investment Management, a hedge fund with $100 mn in assets under management, he observes that even though smaller institutions may not be able to afford to hire additional in-house staff, they too are decreasing their dependence on Wall Street research. What are they using instead? Research from pure-play independent research firms. 'A few years ago we used to use more Wall Street research than we do now. Over the last two years we have gotten to the point of total exclusion of sell-side research,' he reports.

The probing question is, if American Pegasus's research budget were to increase, would the fund purchase more outside research or hire additional analysts to work in-house? 'I'd say we would probably bring in a new analyst,' Chui replies. 'The key reason is that paying for outside research has limited value because there are so many people reading the same report. The true value is not in the research, but in the analysis.'

Delisle says few analysts at smaller and mid-size buy-side firms have the luxury of focusing on specific sectors of the market. They are driven more by a fund's specific investment criteria than they are by the individual sectors themselves, and their resources tend to be more constrained than those of the larger firms. 'A go-anywhere fund at Boston Partners is going to have seven or eight analysts who split up the whole world. A go-anywhere fund at Fidelity will be able to draw upon hundreds of analysts. And you can easily figure out which one is going to have the finer cut on what's going on in each individual sector,' he posits.

Regardless of the number of analysts an institution has, IROs need to understand who the decision-makers are and, specifically, who motivates the decision to buy or sell the stock. In many cases that person will be the portfolio manager. But as the analyst's insight becomes a larger part of the portfolio manager's worldview, the analyst may emerge as the IRO's key contact.

Also, IROs shouldn't assume buy-side analysts know any less about the industry sector than even the best sell-side analysts. Evan Klein, Thomson Financial's executive vice president of capital markets intelligence, says that while buy-side analysts still tend to cover a wider universe of stocks, IROs should be prepared for high-level conversations about their sector. 'As an IRO you would typically think it's the sell side that's going to ask a lot more of the industry-focused questions - getting a lot more granular, a lot more detailed. That might not be the case as much anymore. A Fidelity analyst who comes in probably has just as much information about the sector as a Merrill Lynch sell-side analyst,' he believes.

Clearly the sell side's influence is not as strong as it was even as little as two years ago and therefore, according to Reid, IROs should focus more on speaking to the buy side directly. 'The nice thing about talking with the buy side is that you control the message,' he comments. He advises IROs to know analysts' estimates cold, review all the sources of information out there about the company and know all of the Street's other pertinent projections. If done correctly, he believes, a company can walk into a meeting with the buy side and essentially create its own consensus.

Direct communication with the buy side is the IRO's most direct path to the ultimate destination: the investor's money.