Coming of Age
A Brief History of the Changing Role of the Securities Analyst
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mark andresen |
From green-eyeshade-wearing, slide-rule-toting, underpaid, inconsequential “statisticians,” to highly respected, well-paid, recognized experts on major industries and their most interesting companies—over the last half century the securities analyst has been transformed from peon to potentate. Motivated by the recognition, now universal, that analysts’ judgments move markets, change securities prices, and impact corporate strategies, the evolution of the analyst has been, albeit unevenly, a global phenomenon.
THE LITTLE BLACK BOOK
In the 1950s, when the New York Stock Exchange trading volume averaged just over one million shares, there were no institutional research departments on Wall Street because very few institutions invested actively in stocks. Most institutions and virtually all stockbrokerage firms were still so focused on the cost-avoiding disciplines of the thirties and forties that they could not anticipate the coming boom in institutional investing that would have a constructively compounding effect on research on both sides of the Street.
Back then, bank trust departments—mainly serving individual trust beneficiaries—were the largest buyers and sellers of stocks. The banks directed most of their fixed-rate commissions to the brokerage firms that kept large balances of demand deposit because the commissions “paid” for those balances. These relationships were carefully monitored on both sides and commissions were expected to reach 5%–6% of the stable demand deposit balances.
In a related arrangement, mutual funds “paid” a similar going rate for retail sales of their funds. As a result, most commissions were spoken for by “recip,” as those reciprocal business relationships were usually called. Most of the remaining commissions were “directed”: bank trust customers could and did direct commissions to brokers who were personal friends. Investment counsel firms focused on individuals, worried about taxes, and traded little. Their commissions were dedicated largely to paying recip for accounts introduced by retail brokers.
Big trust departments were usually found at money center banks. Since banks were not allowed to branch across state lines, several cities were considered major “money centers”—Chicago, Boston, Philadelphia, Pittsburgh, Atlanta, Los Angeles, San Francisco, Detroit, etc. Each bank had its own trust department with its own research department. As commissions increased beyond the need for recip, these banks would become important customers for Wall Street.
Insurance companies were the next largest group; their headquarters in Hartford and Ohio made those locations relatively important to Wall Street. A few mutual funds were developing rapidly in Boston and New York City—and also in Kansas City and Minneapolis, where IDS had its own direct sales force. That meant it did no recip business for sales, so all its commissions were available to Wall Street.
In the 1950s, the only person in “research” at Goldman Sachs was Nat Bowen. Here, and elsewhere in this article, excerpts from my book The Partnership (Penguin, 2008), which tells the tale of Goldman Sachs’s extraordinary rise to leadership, have been adapted to illustrate this history of the analyst’s changing role. Bowen’s story is as follows:
Research was a sideline for Bowen, who occasionally helped salesmen and a few customers with the important financial information he packed into the pages in his midsize, three-ring black notebook—information on the companies where senior partner Sidney Weinberg was a director. Bowen never gave anyone his little black book to read, but he would use it to check the facts before offering “guidance” on current developments at the three dozen companies he tracked very carefully. Having all the facts on those companies was essential to Bowen; his job as assistant to Sidney Weinberg was to keep all the important data on Weinberg’s numerous companies in one place for quick reference so he could brief “Mr. Director” on financial and operating details just before each of his many board meetings. Bowen’s briefings helped Weinberg greatly as he built his reputation for being the best-informed director at the many companies he served.
For salesmen Bowen considered sufficiently serious, he was willing to answer questions and to meet occasionally with their more thoughtful clients. Of course, in today’s more regulated market Bowen would have been doling out prohibited “insider information,” but in the fifties the boundary lines were not only much less clearly defined, they were farther apart on the behavior allowed. “Nat Bowen was a great help,” remembers partner Bob Menschel. “We’d arrange quiet lunches with Nat and key accounts. While he wouldn’t give away his little black book, he would consult the data he had packed inside and give broad indications of how a company was doing. Nat had all the facts, and the accounts knew it. So even though he said little, he knew his stuff and clients appreciated his perspective.”
Later in the fifties, the link between statisticians and sales began to be regularized, with George Boyer, a statistician, talking to the salesmen about companies and stocks in the late afternoon when there was no real business to be done because the stock market had closed for the day. Goldman Sachs still had very little franchise in underwriting or in research, so salesmen were always looking for an entry point with each institutional account. Superior research gave Goldman Sachs analysts and salesmen preferential access to the institutional analysts and portfolio managers who were making the decisions, and knowing in advance what stocks might be bought or sold helped Goldman Sachs increase its share of trading volume. Trading was where the profits were.
Research as a specific function at Goldman Sachs—and in Wall Street—developed slowly until the sixties. Securities analysts, still called statisticians, were hired to provide useful data for investment banking and arbitrage. In the early sixties, as a series of research-boutique firms were formed to go after the rapidly expanding institutional stockbrokerage business, Bob Danforth agreed to organize a research department to provide research for institutional investors––but primarily to uncover attractive investment ideas for Goldman Sachs partners’ personal accounts. “The firm had only six or eight people in research,” recalls Menschel. “Danforth covered paper, Nick Petrillo covered rails, and Lou Weston covered financials. We put out one four-page report each month: one page on rails, one on industrials, one on utilities, and one on financials.” Danforth was a canny stock picker who turned down a partnership invitation because he wanted to be free to invest his own account and use margin for leverage, which partners weren’t allowed to do. (After the boom years of the seventies and eighties, when Goldman Sachs was earning its reputation as Wall Street’s most profitable firm, he acknowledged that the firm had done almost as well as he’d done on his own.) Since Danforth was far more interested in finding attractive personal investments for himself and the firm’s partners than in building and managing a business serving institutional investors, he concentrated on small, emerging growth stocks.
A NEW BREED
The small research team Bob Danforth ran at Goldman Sachs was typical of what most securities firms offered in the early 1960s. Merrill Lynch—focused entirely on its retail business and having no institutional department—produced one- and two-page reports with basic facts and brief descriptions, a little prior history, and even less analysis. First Boston, Morgan Stanley, and Lehman Brothers disdained research reports because those appeared to conflict with their main business of underwriting new corporate issues.
At Salomon Brothers, Sidney Homer was doing research on bonds and the bond market. But most investors thought bonds were and always would be dull and saw no point in credit research beyond the conventional credit ratings. To attract any readership, Homer wisely presented his research judgments in an avuncular way that made pleasant reading.
HC Wainwright did introduce a research service: company reports 10–15 pages long, in a standardized format that could be updated regularly with a description of a given company, its position in its industry, and a series of exhibits showing trends in various financial statistics and ratios, stock prices, and balance sheets. Still, there were no opinions and no projections. In Chicago, Duff & Phelps provided much the same sort of service. So did Standard & Poor’s, in a much shorter form, on double-sided pages kept in loose-leaf binders arranged alphabetically for users’ convenience.
Major changes were afoot, however. Entrepreneurial individuals at a few midsize stockbrokerage firms and at an increasing number of newly formed research-centered firms started to produce substantive industry and company studies, serving a market segment of institutional investors that, although still small, was growing rapidly. Paul Miller at Drexel, Wally Stern at Burnham, Bill Grant at Smith Barney, and Edus Warren at Spencer Trask were among the leaders. They were joined by a proliferation of new, research-oriented firms that would be called the “new breed” on Wall Street: Baker, Weeks & Company; Faulkner, Dawkins & Sullivan; DLJ; AG Becker; Sutro; Auerbach, Pollack & Richardson; Mitchell Hutchins; and so on.
Meanwhile, Benjamin Graham, Nicholas Molodovsky, Lucien Hooper, and a few others were producing articles for the Financial Analysts Journal advocating that securities analysis should become a serious profession, with a written examination required for formal certification as a Qualified Security Analyst, or QSA. Most Wall Streeters were not interested—and derisively said so.
THE GO-TO GUYS
Through the sixties and seventies, at institutions and on Wall Street, the importance of analysts and institutional portfolio managers (who had all trained as analysts) increased at a steady, rapid pace. CEOs and CFOs courted them in private meetings and at small luncheons and dinners at the best restaurants, making available ample time for in-depth discussions of competitive strategies, new products, and future financial plans. Line managers returned their calls promptly and answered probing questions. Senior analysts on Wall Street—often with two to four assistants and good budgets for databases and travel—became the go-to experts for both corporate executives and institutional investors.
Stockbrokers competed for shares of that huge stream with block trading and research—particularly research. The institutions generating the most rapidly rising shares of commissions didn’t offer banking or insurance services. They concentrated on investing and they valued research and—to a lesser extent—block trading as they strove for “performance” they could use to develop new business.
These new entrepreneurial investment management firms had lots of energy and sales presence, and they consistently attributed their impressive performance—then being documented for the first time by objective third-party firms like AG Becker—to research. As their business grew and Wall Street’s recovery in the midseventies was led by institutional trading volume, demand for competent research analysts exploded.
In the late seventies and through the eighties, the institutional business flourished on both sides of the Street, and securities analysts began their rise to stardom.
Investment banks had also moved gradually into research, particularly during the early seventies. Research won over White, Weld & Company; Kidder, Peabody & Company; and finally even First Boston, Lehman Brothers, Merrill Lynch, Morgan Stanley, and Salomon Brothers. They reluctantly realized that they needed research to protect their important businesses in either block trading or underwriting—or both.
Again, Goldman Sachs epitomizes the changes in strategy at the major firms:
Responding to insistent demands from his largest block-trading accounts in the early seventies—“If you don’t help us with the research we want, we won’t continue to use you as our $1 block trader”—Goldman Sachs’s Gus Levy called for a firmwide refocusing from midsize companies and “small-cap” stocks to extensive research coverage of the nation’s larger companies, the companies that dominated institutional investors’ portfolios and their trading—the area where Goldman Sachs was the disproportionate leader. As usual, Levy was impatient to see results.
The partners of Goldman Sachs were divided as to the best strategy for building up a research department to cover large companies. Some wanted to acquire a research-boutique firm, while others wanted to hire away the research department of another major firm. Both groups worried that hiring a full team of analysts one at a time would be too slow. Others argued that with intensive, one-at-a-time recruiting of people who would fit well with Goldman Sachs’s culture and organization, the firm could create an all-star research department and avoid the we–they conflicts that so often afflict firms after a major merger. They pointed out that securities firms are remarkably “tribal” and most mergers go through a costly tribal “fight to the death” until one culture or tribe eventually dominates—usually at great cost to the organization. Goldman Sachs decided to recruit individual analysts who could fit into the firm’s culture, and concentrated on hiring young analysts with rapidly developing “franchise reputations” for expertise in specific industries. Once the core group was established, the firm would revert to the “grow our own” policy that characterized Goldman Sachs.
In retrospect, even though the securities business was under heavy pressure in the early seventies, the strategic buildup in research came at an ideal time. Covering large-cap stocks in research protected Levy’s block-trading profit cornucopia, and research was key to Levy’s firmwide refocus on major companies. Moreover, the firm’s steadily increasing profitability during the seventies—particularly in investment banking—made a major research organization affordable. “It was planned,” insists John Whitehead. “In a time of unsettled conditions on Wall Street, while others were economizing, we saw an opportunity to upgrade the quality of our research department. Our research was soon costing us about six million dollars a year, but we kept telling ourselves that our customers would find a way to pay us for it.”
Deciding to hire franchise analysts and build the firm’s own research department was one thing; actually doing it was another. Analysts are professional doubters and are particularly cautious about their own careers. The firm soon found that prospective recruits were asking skeptical questions about Goldman Sachs’s true commitment to an institutional business—blunt questions like “Why should I trust you?” They pointed to other firms that had made large promises while hiring during favorable markets and had then fired all their newly hired analysts when the stock market and trading volume turned down and profits got squeezed. This concern was particularly strong when analysts were considering joining a firm that was, like Goldman Sachs, dominated by investment banking or trading, rather than agency brokerage. Analysts would have had their fears confirmed if they had heard the powerful administrative partner George Doty say sardonically, “Research is like a parking lot for a movie theatre. You have to have one, but it’s not the business you’re in.”
Research became a core competence among investment managers who were competing for lucrative chunks of corporate and, eventually, public pension funds. Pension assets grew rapidly—with a bull market and steady cash inflows. Plan sponsors left banks and insurance companies and went over to independent investment managers in search of performance. Simultaneously, mutual funds grew as increasing numbers of Americans invested more and more of their savings in them. Those funds competed for “performance” to attract more business and, with increasing portfolio turnover, they generated rapidly rising volumes of commissions. The old recip practices fell away, and the resulting surge in commissions, particularly fixed-rate commissions, was fabulous for stockbrokers. In the late seventies and through the eighties, the institutional business flourished on both sides of the Street, and securities analysts began their rise to stardom.
THE ACADEMY
In the sixties, the academy’s impact on investment analysis had been led by such powerful thinkers as Paul Samuelson, an experienced and successful investor, a superb economist, the author of a series of important articles, and one of the originators of the theory of efficient markets. Investment research attracted stellar scholars like William Forsyth Sharpe, Fischer Black, Jim Lorie, Robert Merton, Myron Scholes, Jack Treynor, Bob Litterman, and Marty Liebowitz. Their brilliance—and the power of the computers they often used—created entirely new ways of thinking about and conducting research on investments. Traditional analysts were wont to deny their theories for the first few decades, but were obliged over time to accept the accumulating evidence and adapt to the overall power of efficient markets by looking for exceptions.
Toward the mid- to late seventies, the professional literature expanded substantially in volume and rose in quality and impact because of the increasing number of serious people attracted to the field and interested in exchanging views. Armed with computers and historical data, leading academics recognized opportunities for developing new knowledge—and gaining tenure. Serious research on securities, which had originated in the thirties with Columbia’s Benjamin Graham and David Dodd’s publication of their seminal book Security Analysis, expanded to include Harvard’s John Burr Williams’s analysis of long-term returns and the National Bureau of Economic Research’s Herman Hickman’s study of credit ratings.
Courses in investing changed dramatically, too. In the 1960s, Harvard Business School had offered only one course, which tracked the activities of a bank trust officer serving the elderly spinster Miss Hilda Heald. Running from 11:30 a.m.–1:10 p.m., the class was notoriously dull, sparsely attended, and aptly nicknamed “Darkness at Noon.” Then, in the 1970s, a completely new course centered on institutional investing was launched by Colyer Crum. Exciting, contemporary, and always challenging, its registrations jumped from 20 to 100 and then 200 and 300 students. Harvard graduates began pouring into investment organizations, as did MBAs from Chicago, Stanford, Columbia, Wharton, Darden, New York University, and Kellogg. Supply and demand for securities analysts took off simultaneously. The seventies and eighties were halcyon days.
BOOMTOWN
Analysts’ rewards—both their compensation and the perks they enjoyed—boomed. Those who had proven themselves as analysts could choose to advance into research management, migrate into portfolio management, or move up into organizational leadership. Each of those alternatives allowed “senior” professionals—in their late thirties and early forties—to become important equity owners. And success as a securities analyst was the key that opened all the doors.
As investment banking firms came to appreciate the impact of research analysts on market power, they incorporated research into their competitive strategies for high-margin shares of market in both mergers and acquisitions and initial product offerings. Inevitably, this led to the investment banking divisions covering 50%—even 100%—of the cost of research at major Wall Street firms.
In the midnineties, Goldman Sachs’s research budget was over $175 million, with analysts producing over 3,500 reports each year covering nearly 2,000 companies in 68 industries plus all the world’s major economies, currencies, and commodities.
As investment banking financed the globalization of Wall Street research, US firms—and to a lesser extent UK firms—spread out to cover the leading companies in major industries all around the world. This expansion fed into institutional investors’ increasing appetite for international diversification and major corporations’ interest in multinational acquisitions and access to the global capital markets. The combination of all these ambitions put research at the vortex of a fast-growing and profitable business.
Soon, it was not unusual for broker analysts to earn over $1 million—sometimes within just 10 years of entering the field. Analysts at investing institutions were far better paid than their cohorts in law and medicine, and arguably led more interesting lives. Those with competitive energy and strong curiosity were flooded with exciting opportunities to travel, meet senior corporate executives, and enjoy the stature of well-respected experts. The perks and the money drew the talent.
EXAGGERATED, UNWARRANTED, UNREASONABLE
At the peak of the boom, investment research suffered its most shameful period. The bidding for “deal-maker” analysts and the resulting corruption of Wall Street research in the dot-com era led to the infamous “analysts’ case” of Eliot Spitzer and was epitomized by the competition for individuals like Jack Grubman.
In 2003 Goldman Sachs would be fined $110 million for violating rules of the National Association of Securities Dealers, the industry’s self-regulatory organization, and of the New York Stock Exchange in an action brought before Judge William H. Pauley in US District Court. The essential issue was that research analysts, at Goldman Sachs and elsewhere, while presenting their work as objective and unbiased, were in fact distorting their recommendations to help the firm win investment banking business during the dot-com bubble of 1999–2001.
The court found that the firm knew about the conflicts but failed to establish policies and procedures to detect and prevent the conflicts. In their individual plans, analysts had been expected to tell how they planned to support investment banking. Analysts were asked to identify companies where their relationship with senior management was stronger or better than the firm’s investment banking relationship and to suggest how that could be used to enhance the firm’s business opportunities.
In the worst cases, highly favorable research reports were sent out to clients recommending stocks that informal internal e-mails proved were simultaneously being knocked as junk. The conflicts of interests were blatant when uncovered by New York State Attorney General Eliot Spitzer and the SEC, with help from whistle-blowers and access to e-mails. There were alarming violations of NASD and NYSE rules against “acts or practices contrary to fair dealing.”
Judge Pauley found, “In several instances Goldman Sachs issued certain research reports for companies that were not based on principles of fair dealing and good faith and did not provide a sound basis for evaluating facts, contained exaggerated or unwarranted claims about these companies, and/or contained opinions for which there was no reasonable basis.”
Goldman Sachs and other firms were ordered to pay civil penalties. It was clear that the penalties would be large. The question was how large, and the most important part of “large” was relative—relative to the other major firms that were major competitors. The most important competitor was Morgan Stanley, particularly in reputation, but also in research and in investment banking.
Chairman Hank Paulson called in Bob Steel, vice chairman and head of the equities division. “Bob, your job is to get a settlement that makes Goldman Sachs look okay—okay compared to Morgan Stanley. It may well be that our analysts did worse things than theirs did, so your job is clear: make sure our firm [fares] no worse than their firm.”
Steel “won.” He got a fine of $110 million for Goldman Sachs, while Morgan Stanley paid $125 million.
According to court findings, one analyst defined the three most important goals for 2000 as: “1. Get more investment banking revenue. 2. Get more investment banking revenue. 3. Get more investment banking revenue.” An analyst decided not to lower a company’s earnings estimates solely because it was too close in time to an IPO. Goldman Sachs and the nine other defendants were required by the consent decree to separate research and banking into different organizational units with separate reporting lines; to prevent any input from banking about analysts’ compensation; to prevent analysts from participating in new-business solicitations; to erect “firewalls” to prevent communication between research and banking about potential business; and to prohibit analysts’ participating in road shows prior to an underwriting. The decree required a set of standardized disclosures of a firm’s economic interests in each company being evaluated and required each defendant firm to pay for and provide to its investor clients third-party research from at least three independent firms, to provide tracking measures of past research by each of the firm’s published analysts, and to pay for an independent monitor to assure compliance.
HERE AND NOW
Even after the profession’s chastisement by Spitzer and the Securities and Exchange Commission, the ranks of analysts have continued to swell. The number of people involved in the CFA® (Chartered Financial Analyst®) program, for example, has grown like Topsy.
CFA charterholders are those who have passed a rigorous tripartite examination, who maintain membership in CFA Institute, and who have joined one of the Institute’s local chapters, of which NYSSA (New York Society of Security Analysts) is the largest. While the highest concentration of individuals holding the CFA designation is in the United States, the strongest growth in the numbers of CFA candidates and charterholders has been and is expected to continue to be in other countries. Increases outside the US are projected at 2.5 times the US increase. Ambitious candidates in 134 nations work strenuously to take their places in what they believe to be the top echelon of investment professionals around the world. Ben Graham and Dave Dodd would be pleased.
*The first CFA designations were awarded in 1963.
Sources: Craig Lindquist, CFA Institute, and William Drawbridge, NYSSA, 2008.
So the dark days of investment research passed and analysts went back to their real work: carefully researching and rigorously analyzing company financials, industry trends, competitive developments, and current market valuation. The tools at their disposal have changed in marvelous ways. Analysts have access to Bloomberg and other powerful data providers; to computer models of major companies; to flash faxes and conference calls; and to Internet distribution of everything from minor updates to full reports and live or video conferences. Gone are the days of special confidential briefings, small meetings for selected analysts, or any hope of obtaining advance information or insight from private CEO or CFO meetings.
At the larger investing institutions, careers in research are now par for the course. Most analysts cover 20–30 companies across three to five industries and expect to develop their own ideas for investments. They say they rely on Wall Street research only for industry data, company specifics, and reports on current developments—the raw materials that the institutional analysts organize and compose into their own “proprietary” research recommendations.
Charley Ellis, PhD, CFA, served three decades as the managing partner of Greenwich Associates, where he consulted with institutional investors and securities dealers. He now consults on investing with institutions in the US, Singapore, Vietnam, and Saudi Arabia, and is a director of Vanguard. He is the former chair of the board of governors and two-term governor of CFA Institute (previously AIMR®).
Indented portions of this article are adapted from The Partnership, by Charles D. Ellis. Published by arrangement with The Penguin Press, a member of Penguin Group (USA), Inc. Copyright © Charles D. Ellis, 2008.
