Word on the Street
Waheed Hassan hardly reminds anyone of Gordon Gekko. A 31-year-old stock analyst with a high, boyish voice, Hassan founded his Potomac Falls, Virginia-based independent stock research firm in May 2003, with two other partners. Hassan's firm, Investology, remains tiny, with only one full-time employee. Unlike analysts at big investment banking firms, Hassan doesn't appear on CNBC in sharp suits, give frequent quotes to The Wall Street Journal or expense fancy lunches. No, Investology toils in relative obscurity, focusing on stocks of companies most Americans have never heard of. "We do research on small capitalization stocks," says Hassan. "Merrill Lynch, Morgan Stanley-they don't cover small caps [today], so it's an opportunity for us."
These days, there are more and more Waheed Hassans, and fewer and fewer Gordon Gekkos. Over the past three years, as IT has made it easier for entrepreneurs to sell stock research, and as scandals involving Wall Street brokerages have sullied the image of the largest firms, the market for independent stock research and analysis has opened up. And savvy entrepreneurs like Hassan are stepping into the breach, taking business from the financial giants. Indeed, despite its hand-to-mouth existence, Investology's independent research has already won the company a relationship with one of the bigger U.S. pension funds.
The Scandal Effect
For decades, most stock research was handled by large firms that employed reams of analysts to cover a wide range of stocks. But they didn't just analyze stocks: The big boys also made money with financial advisors, brokers and investment bankers.
Since 2000, however, investigations by financial watchdogs have revealed that some of the larger firms' stock research was not truly independent. Corporate chiefs at the bigger investment houses were pressuring analysts to rate certain stocks highly so their brokers and investment bankers could sell more of the stock, and the investment houses could then benefit from public offerings of stocks they had touted.
Many individual investors-especially those who jumped into the market in the go-go '90s-believed the analysts were independent and lost billions betting on their recommendations. In the wake of a multiyear investigation into the big firms' research, 10 large Wall Street firms admitted their wrongdoing and, in April 2003, paid a $1.4 billion fine.
These scandals have given entrepreneurs two historic opportunities. First, as larger Wall Street investment houses faced huge fines for their actions, they had to cut costs. Big Wall Street houses laid off hundreds of stock analysts who had the expertise needed to offer high-quality research, with several firms cutting as much as 40 percent of their staff. Consequently, the big firms simply stopped monitoring whole groups of stocks, like the small caps that Investology focuses on.
David Riedel was one of those experts. In 2002, Riedel was laid off as an analyst at Salomon Smith Barney. "I realized there were huge opportunities [due to] the breakdown in certain types of research by bigger firms," he says. With a strong background in Asia-Riedel got a graduate degree in business from a Thai university, speaks Thai and Chinese, and had analyzed Asian stocks in the mid-'90s for Salomon Brothers-he decided that Asia would be his niche. As the larger firms downsized, they cut most of their independent research on the ground in Asian markets outside China and Japan, Riedel says. Yet, in the past three years, he says, these Asian markets have posted some of the strongest growth in the world. Seeing that hole, in May 2003 Riedel started his own company, Riedel Research Group Inc., out of his New York City loft.
Riedel, 37, hired seven local analysts in three Southeast Asian countries, and hit the ground fast, focusing on Indonesia, Malaysia and Thailand. The internet made it even easier for him to get started. After hiring Thai analysts through local word-of-mouth, he turned to an Asian online job board to find his other analysts and has been thrilled with the quality of their research.
With a niche in place, he started drawing on old connections, emphasizing that he was offering services others didn't. "I pitched my research to [mutual and pension] fund managers who have holdings in Asia [and] are being poorly served by big investment firms [that] don't have analysts on the ground," Riedel says.
Six clients quickly signed up with Riedel, and he plans to have 30 by year's end. Riedel believes his on-the-ground information, tailored to his customers, has paid off. He advised clients not to pull out of holdings in Indonesia, despite the country's recent political instability due to terrorist attacks. This year, Indonesia quieted down, held a peaceful presidential election, and watched its stocks soar.
A Matter of Trust
The scandals have not only left more stocks ignored by large companies-they've also eroded Americans' trust in large Wall Street firms' advice. In fact, polls now consistently show that average investors mistrust nearly all the larger firms' research. "We get many people walking in here for the first time specifically because they don't trust the bigger names," says Emily Sanders, 50, founder and president of Sanders International Inc., a small financial advisory and investment management firm in Norcross, Georgia. "They think it'll be easier to hold us accountable." Indeed, while Sanders once shied away from advertising that her firm was small for fear investors equated small with lack of expertise, now she openly advertises her company's size to lure customers.
Sanders, too, has found a niche, which is crucial to smaller investment houses. Sanders International focuses on affluent young women, whom she believes are still treated shabbily by larger, male-dominated Wall Street firms. "They talk down to [women investors] all the time. We never do," she says. Today, Sanders manages over $80 million in client assets, and 50 percent of her customers are women, a high figure in the industry.
Some small financial companies will benefit directly from the big firms' $1.4 billion settlement. As part of the fine, the 10 big investment houses will pay roughly $450 million for independent research not tainted by ties to brokers and investment bankers. As further punishment, the 10 big boys will be required to post the independents' research on the big firms' own websites, a kind of free advertising for entrepreneurial investment firms. Already, a group of five small investment research houses have banded together, forming a consortium called Best Independent Research, to provide research to the big firms' sites and toll-free investor hotlines. Meanwhile, the Bank of New York has signed agreements with more than 150 independent suppliers to distribute their research.
Though other small companies may not benefit directly, smart entrepreneurs have used the big firms' troubles to convince clients that small research is better. "We're so different from the Wall Street firms because they make money selling stocks, and we only make money doing research," says Chris Hackett, who started his own firm, Greenwich Investment Research Inc., in December 2001 out of his Greenwich, Connecticut, home. To show he stood behind his work, unlike the larger firms, Hackett took a bold risk. From the start, he invested his own money in the stock picks his firm touts. "I put my retirement funds, my investment for my kids, into every piece of research we do, and we stay in that position alongside our clients," Hackett says. "When you're betting your own money, you really don't want to make a mistake."
Hackett focuses on high-end professional investors, including some of the biggest mutual and pension funds, selling them his intensely detailed research reports-dense 20- to 30-page documents he compares to "a thick issue of The Economist"-for a fee of $20,000 annually. Hackett also does extra, tailored, follow-up research on any stock for a customer. "We wouldn't want to get too big-it's really important that we have a direct relationship with clients," Hackett says. Still, "Hackett's Special Situation Report" has proven profitable enough that the two-person firm recently added a marketing expert.
Hackett believes his research is simply better. "We look for anoma-lies in the market that bigger firms miss," he says. Hackett points to CenterPoint Energy, a Houston-based power corporation, as an example. "Everyone on Wall Street hated [CenterPoint] last year. It was at $5 a share because they'd done some stupid things on their balance sheet," he says. "But amidst the mess, they had strong earnings. We went against everyone from Wall Street-my dad's own stockbroker told him not to invest with me in it. But it was a no-brainer." Today, CenterPoint trades at nearly $11 per share, and clients of "Hackett's Special Situation Report" reaped huge profits.
For people without knowledge of investment advising, getting into the business seems like a snap. There are relatively low barriers to entry, since it doesn't take much capital to open an office, and getting certified as an advisor is not difficult in most states.
But building the kind of trust that attracts clients is much harder. Emily Sanders, founder and president of investment advisory firm Sanders International Inc. in Norcross, Georgia, believes finding a market niche is crucial. In her case, it's affluent women-an underserved client base. Similarly, Jennifer Black, a financial analyst who formed Jennifer Black & Associates from her home in Lake Oswego, Oregon, has focused on researching apparel and retail companies, becoming an expert in these areas.
Once they find that niche, savvy entrepreneurs use unconventional ways to reach these clients. Big financial firms tend to attract clients through traditional advertising and word-of-mouth, which can be expensive and time-consuming. But Sanders, for instance, has become a corporate contributor to the Atlanta Women's Foundation, a nonprofit organization, to help promote her services and net new clients.
Perhaps most important, given the current skepticism toward investment research, entrepreneurial advisors must promote their independence, the key advantage that sets them apart from the big boys. Small financial advisors simply have to use every opportunity to emphasize that because they don't have brokerage operations, their research can't be tainted.
But even as the financial industry changes, it's hardly easy going for entrepreneurs. Selling research on larger capitalization stocks-the big, well-known companies that are interesting to a wider range of investors-remains tough sledding for small firms. "I can't compete with [bigger firms] writing a report on IBM," says Hassan. "They have too many analysts on it." Indeed, even midsize research companies like Chicago-based Morningstar, which has made itself a brand name in the industry, often shy away from doing detailed research on the biggest caps.
Still, independent research firms can be proud of the strides they've made. A new study by three eminent finance professors-Brett Trueman of University of California, Los Angeles; Brad Barber of University of California, Davis; and Reuven Lehavy of University of Michigan, Ann Arbor-found that independent stock firms made more accurate stock picks between 1996 and 2003 than the larger Wall Street companies. In the weaker, post-2000 stock market, the independents outperformed the larger investment firms by an even wider margin, perhaps because the independents were not worried that downgrading companies would hurt their brokers' abilities to sell stocks. If they keep it up, maybe one day entrepreneurs like Waheed Hassan will rule Wall Street.
One reason the smaller companies have a chance in the investment business today is that many Americans no longer trust the big boys. Over the past four years, a series of scandals have suggested that some of the analysis of larger investment firms is Biased. Here are just a few of the highlights-or lowlights.
After an investigation by regulators into conflicts of interest in its research and analysis department, Merrill Lynch pays a $100 million fine. In the investigation, e-mail messages by leading Merrill Lynch analyst Henry Blodget leak to the press. The e-mails suggest that several of the analysts, including Blodget, publicly talked up stocks that in private they disdained-stocks whose investment banking business Merrill wanted to win. Later, similar e-mails come out at other top firms.
New York Attorney General Eliot Spitzer files suit against top officials from five telecommunications companies, arguing that they gave investment banking business to Citigroup in a deal to have Citigroup analysts boost the ratings of their stocks.
In an ongoing investigation by regulators into conflicts of interest at several other top Wall Street houses, including Goldman Sachs, Morgan Stanley and Citigroup Global Markets (formerly Salomon Smith Barney), the big firms agree to pay a whopping $1.4 billion fine.
Spitzer and the SEC announce that they've launched another investigation-this one into conflicts of interest among several of the largest mutual fund firms.
Citigroup Global Markets fires four of its brokers after further investigation into their trading practices.
The SEC announces a new set of ethics codes for mutual funds, requiring them to provide more disclosure of some of their trading practices.
Janus Capital Group, one of the larger American mutual fund groups, agrees to pay a fine of $226.2 million after an investigation by regulators into improper trading.
Joshua Kurlantzick is a writer in Washington, DC.