Word on the Street Scandal-ridden investment houses are leaving gaps in the financial market, and savvy entrepreneurs are jumping at the chance to fill them. How will this trend shape the new face of Wall Street?
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Waheed Hassan hardly reminds anyone of Gordon Gekko. A31-year-old stock analyst with a high, boyish voice, Hassan foundedhis Potomac Falls, Virginia-based independent stock research firmin May 2003, with two other partners. Hassan's firm, Investology,remains tiny, with only one full-time employee. Unlike analysts atbig investment banking firms, Hassan doesn't appear on CNBC insharp suits, give frequent quotes to The Wall Street Journalor expense fancy lunches. No, Investology toils in relativeobscurity, focusing on stocks of companies most Americans havenever heard of. "We do research on small capitalizationstocks," says Hassan. "Merrill Lynch, Morgan Stanley-theydon't cover small caps [today], so it's an opportunity forus."
These days, there are more and more Waheed Hassans, and fewerand fewer Gordon Gekkos. Over the past three years, as IT has madeit easier for entrepreneurs to sell stock research, and as scandalsinvolving Wall Street brokerages have sullied the image of thelargest firms, the market for independent stock research andanalysis has opened up. And savvy entrepreneurs like Hassan arestepping into the breach, taking business from the financialgiants. Indeed, despite its hand-to-mouth existence,Investology's independent research has already won the companya relationship with one of the bigger U.S. pension funds.
The Scandal Effect
For decades, most stock research was handled by large firms thatemployed reams of analysts to cover a wide range of stocks. Butthey didn't just analyze stocks: The big boys also made moneywith financial advisors, brokers and investment bankers.
Since 2000, however, investigations by financial watchdogs haverevealed that some of the larger firms' stock research was nottruly independent. Corporate chiefs at the bigger investment houseswere pressuring analysts to rate certain stocks highly so theirbrokers and investment bankers could sell more of the stock, andthe investment houses could then benefit from public offerings ofstocks they had touted.
Many individual investors-especially those who jumped into themarket in the go-go '90s-believed the analysts were independentand lost billions betting on their recommendations. In the wake ofa multiyear investigation into the big firms' research, 10large Wall Street firms admitted their wrongdoing and, in April2003, paid a $1.4 billion fine.
These scandals have given entrepreneurs two historicopportunities. First, as larger Wall Street investment houses facedhuge fines for their actions, they had to cut costs. Big WallStreet houses laid off hundreds of stock analysts who had theexpertise needed to offer high-quality research, with several firmscutting as much as 40 percent of their staff. Consequently, the bigfirms simply stopped monitoring whole groups of stocks, like thesmall caps that Investology focuses on.
David Riedel was one of those experts. In 2002, Riedel was laidoff as an analyst at Salomon Smith Barney. "I realized therewere huge opportunities [due to] the breakdown in certain types ofresearch by bigger firms," he says. With a strong backgroundin Asia-Riedel got a graduate degree in business from a Thaiuniversity, speaks Thai and Chinese, and had analyzed Asian stocksin the mid-'90s for Salomon Brothers-he decided that Asia wouldbe his niche. As the larger firms downsized, they cut most of theirindependent research on the ground in Asian markets outside Chinaand Japan, Riedel says. Yet, in the past three years, he says,these Asian markets have posted some of the strongest growth in theworld. Seeing that hole, in May 2003 Riedel started his owncompany, Riedel Research Group Inc., out of his New York Cityloft.
Riedel, 37, hired seven local analysts in three Southeast Asiancountries, and hit the ground fast, focusing on Indonesia, Malaysiaand Thailand. The internet made it even easier for him to getstarted. After hiring Thai analysts through local word-of-mouth, heturned to an Asian online job board to find his other analysts andhas 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 managerswho have holdings in Asia [and] are being poorly served by biginvestment firms [that] don't have analysts on theground," Riedel says.
Six clients quickly signed up with Riedel, and he plans to have30 by year's end. Riedel believes his on-the-groundinformation, tailored to his customers, has paid off. He advisedclients not to pull out of holdings in Indonesia, despite thecountry's recent political instability due to terroristattacks. This year, Indonesia quieted down, held a peacefulpresidential election, and watched its stocks soar.
A Matter of Trust
The scandals have not only left more stocks ignored by largecompanies-they've also eroded Americans' trust in largeWall Street firms' advice. In fact, polls now consistently showthat average investors mistrust nearly all the larger firms'research. "We get many people walking in here for the firsttime specifically because they don't trust the biggernames," says Emily Sanders, 50, founder and president ofSandersInternational Inc., a small financial advisory and investmentmanagement firm in Norcross, Georgia. "They think it'll beeasier to hold us accountable." Indeed, while Sanders onceshied away from advertising that her firm was small for fearinvestors equated small with lack of expertise, now she openlyadvertises her company's size to lure customers.
Sanders, too, has found a niche, which is crucial to smallerinvestment houses. Sanders International focuses on affluent youngwomen, whom she believes are still treated shabbily by larger,male-dominated Wall Street firms. "They talk down to [womeninvestors] all the time. We never do," she says. Today,Sanders manages over $80 million in client assets, and 50 percentof her customers are women, a high figure in the industry.
Some small financial companies will benefit directly from thebig firms' $1.4 billion settlement. As part of the fine, the 10big investment houses will pay roughly $450 million for independentresearch not tainted by ties to brokers and investment bankers. Asfurther punishment, the 10 big boys will be required to post theindependents' research on the big firms' own websites, akind of free advertising for entrepreneurial investment firms.Already, a group of five small investment research houses havebanded together, forming a consortium called Best IndependentResearch, to provide research to the big firms' sites andtoll-free investor hotlines. Meanwhile, the Bank of New York hassigned agreements with more than 150 independent suppliers todistribute their research.
Though other small companies may not benefit directly, smartentrepreneurs have used the big firms' troubles to convinceclients that small research is better. "We're so differentfrom 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 2001out of his Greenwich, Connecticut, home. To show he stood behindhis work, unlike the larger firms, Hackett took a bold risk. Fromthe start, he invested his own money in the stock picks his firmtouts. "I put my retirement funds, my investment for my kids,into every piece of research we do, and we stay in that positionalongside our clients," Hackett says. "When you'rebetting your own money, you really don't want to make amistake."
Hackett focuses on high-end professional investors, includingsome of the biggest mutual and pension funds, selling them hisintensely detailed research reports-dense 20- to 30-page documentshe compares to "a thick issue of TheEconomist"-for a fee of $20,000 annually. Hackett alsodoes extra, tailored, follow-up research on any stock for acustomer. "We wouldn't want to get too big-it's reallyimportant that we have a direct relationship with clients,"Hackett says. Still, "Hackett's Special SituationReport" has proven profitable enough that the two-person firmrecently added a marketing expert.
Hackett believes his research is simply better. "We lookfor anoma-lies in the market that bigger firms miss," he says.Hackett points to CenterPoint Energy, a Houston-based powercorporation, as an example. "Everyone on Wall Street hated[CenterPoint] last year. It was at $5 a share because they'ddone some stupid things on their balance sheet," he says."But amidst the mess, they had strong earnings. We wentagainst everyone from Wall Street-my dad's own stockbroker toldhim 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 hugeprofits.
For people without knowledge of investment advising, gettinginto the business seems like a snap. There are relatively lowbarriers to entry, since it doesn't take much capital to openan office, and getting certified as an advisor is not difficult inmost states.
But building the kind of trust that attracts clients is muchharder. Emily Sanders, founder and president of investment advisoryfirm Sanders International Inc. in Norcross, Georgia, believesfinding a market niche is crucial. In her case, it's affluentwomen-an underserved client base. Similarly, Jennifer Black, afinancial analyst who formed Jennifer Black & Associates fromher home in Lake Oswego, Oregon, has focused on researching appareland retail companies, becoming an expert in these areas.
Once they find that niche, savvy entrepreneurs useunconventional ways to reach these clients. Big financial firmstend to attract clients through traditional advertising andword-of-mouth, which can be expensive and time-consuming. ButSanders, for instance, has become a corporate contributor to theAtlanta Women's Foundation, a nonprofit organization, to helppromote her services and net new clients.
Perhaps most important, given the current skepticism towardinvestment research, entrepreneurial advisors must promote theirindependence, the key advantage that sets them apart from the bigboys. Small financial advisors simply have to use every opportunityto emphasize that because they don't have brokerage operations,their research can't be tainted.
Small Wonders
But even as the financial industry changes, it's hardly easygoing for entrepreneurs. Selling research on larger capitalizationstocks-the big, well-known companies that are interesting to awider range of investors-remains tough sledding for small firms."I can't compete with [bigger firms] writing a report onIBM," says Hassan. "They have too many analysts onit." Indeed, even midsize research companies likeChicago-based Morningstar, which has made itself a brand name inthe industry, often shy away from doing detailed research on thebiggest caps.
Still, independent research firms can be proud of the stridesthey've made. A new study by three eminent financeprofessors-Brett Trueman of University of California, Los Angeles;Brad Barber of University of California, Davis; and Reuven Lehavyof University of Michigan, Ann Arbor-found that independent stockfirms made more accurate stock picks between 1996 and 2003 than thelarger Wall Street companies. In the weaker, post-2000 stockmarket, the independents outperformed the larger investment firmsby an even wider margin, perhaps because the independents were notworried that downgrading companies would hurt their brokers'abilities to sell stocks. If they keep it up, maybe one dayentrepreneurs like Waheed Hassan will rule Wall Street.
Scandalous!
One reason the smaller companies have a chance in the investmentbusiness today is that many Americans no longer trust the big boys.Over the past four years, a series of scandals have suggested thatsome of the analysis of larger investment firms is Biased. Here arejust a few of the highlights-or lowlights.
May 2002:
After an investigation by regulators into conflicts of interestin its research and analysis department, Merrill Lynch pays a $100million fine. In the investigation, e-mail messages by leadingMerrill Lynch analyst Henry Blodget leak to the press. The e-mailssuggest that several of the analysts, including Blodget, publiclytalked up stocks that in private they disdained-stocks whoseinvestment banking business Merrill wanted to win. Later, similare-mails come out at other top firms.
October 2002:
New York Attorney General Eliot Spitzer files suit against topofficials from five telecommunications companies, arguing that theygave investment banking business to Citigroup in a deal to haveCitigroup analysts boost the ratings of their stocks.
December 2002:
In an ongoing investigation by regulators into conflicts ofinterest at several other top Wall Street houses, including GoldmanSachs, Morgan Stanley and Citigroup Global Markets (formerlySalomon Smith Barney), the big firms agree to pay a whopping $1.4billion fine.
September 2003:
Spitzer and the SEC announce that they've launched anotherinvestigation-this one into conflicts of interest among several ofthe largest mutual fund firms.
October 2003:
Citigroup Global Markets fires four of its brokers after furtherinvestigation into their trading practices.
May 2004:
The SEC announces a new set of ethics codes for mutual funds,requiring them to provide more disclosure of some of their tradingpractices.
August 2004:
Janus Capital Group, one of the larger American mutual fundgroups, agrees to pay a fine of $226.2 million after aninvestigation by regulators into improper trading.
Joshua Kurlantzick is a writer in Washington, DC.
