David R. Evanson
On Wall Street, Summer, 2003
A Whozzs Who of Independent Research: When your firm starts providing outside research, youzzll want to know some of the leaders.
August 1, 2003
In the wake of the “global settlement” — the April agreement among 10 investment banking firms and the Securities and Exchange Commission — brokers and advisors soon will find lots more independent research reports on their desks.
Even though current market conditions may have dampened enthusiasm for equities in general, many investors and advisors are looking forward to the new landscape.
“The way research has been conducted canzzt change soon enough,” says Janet Fox, a principal with the financial planning firm of ACH Investments in Raleigh, N.C., who, along with many of her investors, was stung by bullish WorldCom recommendations. “Izzm disappointed that we had to go through this and our investors had to go through this; Izzm hoping we are now paving the way for better controls.”
One of the provisions of the settlement requires securities firms to contract with independent research providers and make the independent reports available alongside their own research — a practice that may become the de facto standard throughout the industry. Where will all this research come from? Below are five of the top independent research providers. Take a look at their techniques and track records; these firms soon may become a bigger part of your life.
In Greek mythology, Argus was a 100-eyed gatekeeper who saw everything. Argus Research founder Harold Dorsey thought this was an apt moniker for a firm he hoped would be Wall Streetzzs eyes in 1934. With the large brokerage firms of the day still reeling from the Crash, Dorsey put together a team of crack research analysts and sold access to them.
Seventy years later, with the larger brokerages again in a pickle, Argus again sees a role in helping out. According to CEO John Eade, the firm is bulking up to expand its coverage universe to 1,500 stocks. To date, it has focused on 200 of the most widely held stocks and another 100 stocks its analysts believe could move into the top tier.
Argus maintains a simple rating system with just three rankings: buy, sell and hold. Although the outcome is simple, the underlying analysis is complex. According to Eade, Arguszzs 12 analysts work from a top-down research model.
“The firmzzs overall macroeconomic assumptions drive the industries that we focus on, and a six-point analysis results in buy, sell and hold rankings for the top names in each sector that the firm is covering,” says Eade.
At the company level, Argus research consists of a peer, growth, financial strength, risk, valuation and corporate governance analysis. Eade says the Argus valuation analysis looks at a number of benchmarks including discounted cash flow, price-to-book, sales, earnings and cash flow. It establishes bands or ranges for covered equities for 15- to 25-year time frames.
“Because we believe that stocks will trade to a mean, these bands provide us strong indications of whether or not a company is over- or undervalued at any point in time. The other five analyses provide qualitative verification.”
As an example of this top-down approach in action, Argus analysts maintain that the economyzzs current pre-recovery phase favors cyclicals, such as tech and financial services, over consumer staples. As a result, Argus is underweighting the latter, with a buy rating on only 30 percent of the consumer staples stocks they cover, compared to 55 percent rated hold and 15 percent rated sell. Some of the buys include Altria (MO) and PepsiCo (PEP). The sells include Campbell Soup (CPB) and Hershey Foods (HSY), while holds include Gillette (G), Coca Cola (KO) and Sara Lee (SLE).
Lou Denton, chairman and chief executive officer of the Philadelphia Corporation for Investment Services, recently replaced his firmzzs Credit Suisse research with Argus.
“I like the Argus reports because therezzs more meat on them than you get with S&P and Value Line, but they are not 150-page reports that are too much for our reps or our clients,” says Denton, whose firm employs 25 brokers. “With Credit Suisse research getting bad publicity there were issues. Also, they covered too many stocks; you could not keep up with it.”
Global Capital Institute
Unlike better-known independent research providers that market to the sell-side, Global Capital Institute (GCI) has provided research to asset managers, including Thomas White International, for more than 10 years. GCI founder Tom White says that in light of the global settlement, he is repackaging his research for retail audiences to compete for the so-called “settlement business.”
The research that Global Capital Institute offers today was originally designed as a proprietary model for legendary investor and money manager John Templeton. Because of this heritage, as well as an institutional focus, GCI research has a quantitative bent.
White says GCI has divided the market into 98 groups, or valuation baskets, and uses industry-specific valuation techniques. “Try to compare a food manufacturer — which expenses almost everything as it develops and sells product — to an oil company, where product development and production have a huge impact on the balance sheet. You simply cannot value the two firms using the same metrics.”
GCI conducts extensive fundamental analysis, combining hard data and a dollop of analyst intuition, to rank stocks by their two-year expected returns. Stocks with the highest expected returns relative to the others are ranked one, or a strong buy, while stocks with the lowest relative two-year expected returns are ranked 10, or most unattractive. White says the research product he is creating for retail investors in light of the global settlement will compress those rankings from one, for strong buy, to five, a strong sell.
In terms of performance, GCI has proven its mettle. A composite portfolio consisting of long positions on GCI buys and short positions on its sells returned 9.33 percent over the past three years, second behind Standard & Poorzzs for firms covering more than 500 equities.
White has bundled his research with that of four other independent providers — Callard Research, Channel Trend, Columbine Capital Services and Ford Equity Research — to form a consortium called Best Independent Research LLC. All but Callard were ranked among the top seven research firms in terms of three-year performance by Investars.com, a research ranking firm.
Morningstar is trying to extend its dominant mutual fund rating franchise into equities. Catherine Odelbo, president of securities research, says that her 30 securities analysts have 500 stocks under full coverage and another 500 “ladies in waiting” that will come on line as the firm bulks up its analyst staff.
Stocks currently in the coverage universe reflect beliefs unique to Morningstar. First, the firm covers companies of interest to individual investors, not necessarily those that interest institutions. It gets input on these stocks from more than 100,000 customers who use its Web site. Second, Morningstar uses Warren Buffettzzs concept of economic “moats,” which are a set of competitive advantages that enable certain companies to keep competitors at bay while earning excess economic profits.
“We tend to cover more service companies than manufacturing companies,” says Odelbo, “because they tend to have the widest moats.” She adds that the 500 covered stocks represent 85 percent of the S&P 500.
Within this framework, Odelbo says that Morningstar research is driven by a discounted cash flow analysis to determine fair value. Obviously, such a model draws its strength or weakness from the discount rate used. Morningstar looks at operating and free cash flows, debt, cyclicality, overall size, so-called event risks and economic moats to determine the appropriate rate. The method is further refined by a return analysis to determine what a company earns on invested capital. Equities with the greatest discount to their fair value get the highest ratings, and those with a premium over their fair value are assigned a lower rating.
As in mutual funds, Morningstar uses a star rating system in rating equities. Five stars is a strong buy, four represents a buy, three a hold, two a sell and one star a strong sell. Odelbo says that if retail investors who use Morningstar ratings bought five-star stocks and sold them when their rating dropped to one star, the return from August of 2001 through the end of 2002 would be a negative 7.2 percent. That may not be compelling in isolation, but compared to the 23.3 percent loss in the S&P 500 over the same period of time, itzzs not bad.
Standard & Poorzzs
One of the fixtures of independent research is Standard & Poorzzs Corporation, a unit of McGraw-Hill. Venerable S&P has been providing equity research since 1986. According to chief investment strategist Sam Stovall, S&P offers investors qualitative and quantitative research. The quantitative research, known as the Fair Value rankings, offers coverage on 1,200 equities, which consists of most of the stocks in the S&P 500, the S&P Midcap 400 and the S&P SmallCap 400. Standard & Poorzzs also offers qualitative research on 1,200 U.S. equities consisting of roughly the same basket. Stocks receiving a top mark in both categories constitute the S&P Platinum portfolio, which many brokers and advisors use to manage clientszz money.
Standard & Poorzzs qualitative research is based on three separate analyses consisting of an intrinsic analysis, a comparative analysis and a “sum of the parts” valuation. “The intrinsic value analysis is the basis of our opinion,” says Stovall, “with the other two analyses providing substantiation.”
Stovall says the further a stock price is below its intrinsic value, the higher the STAR (Stock Appreciation Ranking) system. Five stars is a strong buy, four means accumulate, three designates a hold, two counsels avoiding and one star specifies sell. According to S&P, a portfolio consisting of strong-buy, five-star stocks would have returned 991 percent since 1986, versus 298 percent for the S&P 500 Index.
Standard & Poorzzs quantitative rankings utilize the firmzzs black-box analysis called Fair Value, which is a three-pronged approach that looks at fundamental data, the likelihood a company will show a positive earnings surprise and timeliness with respect to delivering future capital gains. “The top ranking is 5A+,” says Stovall. “That means five for its fundamental score, an A in terms of the ability to deliver a positive earnings surprise, and a plus, as opposed to a minus, for timing.”
What brokers and advisors like about S&P is not just the research, but the ways in which the firm repackages that information into portfolios that can be used to manage client accounts. Fred Siegel, founder of the New Orleans-based Siegel Group, which oversees $1.5 billion, says, “I like the way they bring the research down into a smaller universe.”
Siegel uses S&Pzzs Neutral Fair Value portfolio, which consists of 20 stocks exhibiting a 5A+ ranking but also trade more than 4 million shares a day and have a debt-to-equity ratio of less than one.
“Itzzs small, updated once a week, and through May of this year was up 16 percent,” says Siegel.
Value Line has been publishing its “timeliness” rankings on equities since 1965 and has been providing investors with information since 1931. If you talk with people at Value Line, they seem to be unfazed by the tectonic plates shifting beneath the world of stock research. They just want to focus on analyzing stocks, an orientation that many brokers and advisors will perhaps find comforting given the wild ride over the past three years.
The Value Line Survey covers 1,700 stocks, which according to research director Steve Sanborn consists roughly of the stocks in the S&P 500, the Russell 1000 and the Nasdaq 100. Says Sanborn, “We pride ourselves on finding growth stocks.”
Value Line ranks stocks according to timeliness, a reference to the fact that the firmzzs raison dzzetre is to advise investors of stocks that will be top performers over the next six to 12 months. Value Linezzs ranking system runs from one to five, with one being the highest, or most timely, ranking. A two is above-average timeliness, three is average timeliness, four is below average, and five is ranked lowest for timeliness.
Sanborn says the Value Line valuation model, at the broadest level, looks at a stockzzs price momentum and earnings growth relative to the other companies in the survey. “Equities that come out with ones and twos are those where earnings have been growing fastest, and where the stock has been acting well relative to the others we are following,” says Sanborn. Further, he notes, price momentum and earnings growth are analyzed over a 10-year time frame to give the analysts historical context, and then again over the most recent six months.
Value Line maintains a constant distribution among its buy, sell and hold rankings. That is, at any one time, there are 100 strong buys, 100 strong sells, 300 buys, 300 sells and 900 neutrals or holds. “The majority of the stocks are going to simply track the market,” says Sanborn. “What wezzre looking for are the outliers that will dramatically outperform or under-perform the market.”
Rick Keller, an Orange County, Calif.-based financial planner who has $530 million under management, has been a subscriber to Value Line for more than 18 years. He likes the 10-year histories each report provides and the fact that the numbers have been “scrubbed.” Despite the impressive history of Value Line buy recommendations, Keller does not follow them.
“A lot of their strong buys are ranked more on their short-term performance than their strength. We restrict ourselves to large caps with strong balance sheets,” he explains.
According to Sanborn, investors new to Value Line, or for that matter new to investing, should “buy stocks ranked one, consider selling them when they are rated three, and definitely sell them when they are ranked four.” He says that according to Value Linezzs analysis, investors who bought only stocks ranked one at the beginning of the year and adjusted each year since the company started doing equity research would have a cumulative return of 12,505 percent, versus 898 percent for the S&P 500.