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In Search of Alpha: Innovation in Securities Research (2/9/06 Harvard Business School Club of CT Panel)

Harvard Business School

I recently was fortunate to participate in a panel discussion on

“In Search of Alpha: Innovation in Securities Research”, sponsored by The Harvard Business School Club of Connecticut, Thursday, Feb. 9, 2006, in Greenwich, CT.

Tom Hutchinson and Michael Mayhew of Integrity Research already blogged about the program here.

Biographies of Panelists:

Michael Mayhew, CEO, Integrity Research Panel Moderator

In 2000 Michael founded Integrity Research Associates, LLC, a syndicated research, ratings and consulting firm whose focus is to help institutional investors identify, evaluate, select, and monitor research providers that can produce a meaningful difference to the bottom line performance of their investment portfolios. Previously, Mike was the Chief Executive Officer and President of Garban Information Systems, the financial information division of a $3.0 billion multinational corporation – Garban/United News & Media. During his 4 � year tenure, Mike grew the company by over 55% in revenue and 80% in profit. Before his stint with Garban, Mr. Mayhew worked as the Director of Strategic Planning & Business Development for Standard & Poor’s $350 million Financial Information Services Group. He was responsible for all strategic planning initiatives, evaluating and establishing product development priorities, and analyzing acquisition and/or divestiture opportunities for the 8 businesses within S&P’s Financial Information Group. Mike started his career in the industry in January 1982 as an economist with MMS International where he analyzed and forecasted the U.S. real sector.

Doug Atkin, President and CEO of Majestic Research

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Doug was previously President and CEO of Instinet Group, where he conducted the IPO (NASDAQ: INGP), developed Instinet’s research, international trading and correspondent clearing businesses, and led a consortium of nine global brokerage firms that took a majority stake in the virt-x stoc exchange. He served on both the Trading Committee and Market Structure Committee of the SIA. Doug was selected one of the Top New Yorkers of 1999 by New York magazine for his leading role in redefining the financial marketplace. In 2000, Institutional Investor profiled Doug as one of the top 10 individuals making the greatest impact on e-finance, and was presented with The Travers Bell Memorial Award of Distinction sponsored by the SIA. Doug serves as a member of the Board of Directors of Starmine and WR Hambrecht. He is a graduate of Tufts University.

Lisa Shalett, Chairman/CEO, Sanford C. Bernstein & Co., LLC, a subsidiary of Alliance Capital

Lisa previously served as Director of Global Research for U.S. and European companies. Prior to taking this position, Lisa served as senior research analyst covering capital goods and diversified industrials. In this position, Ms. Shalett was recognized as an “Up & Coming” analyst by Institutional Investor in 1996 and 1997; in 1998, she joined the Institutional Investor All-America Research team where she remained a top ranked analyst through 2000. Ms. Shalett joined the firm in 1995. Previously, she spent six years as a management consultant at the Boston Consulting Group in New York, covering consumer and technology-intensive industries. From 1985 to 1988, she also held positions at Motorola, Booz, Allen & Hamilton and PepsiCo, Inc. Ms. Shalett holds a dual magna cum laude B.S. in Applied Mathematics & Economics from Brown University and an MBA from Harvard Business School.

David Teten, CEO of Nitron Advisors

Nitron Advisors provides institutional investors with direct access to its Circle of Experts: frontline industry experts: senior executives, scientists, engineers, and academics. Nitron specializes in providing access to executives in transition. David is the coauthor of The Virtual Handshake: Opening Doors and Closing Deals Online, the first book about how to use online networks-blogs, social network sites, virtual communities, and other “social software” technologies. David formerly was CEO of GoldNames, an investment bank focusing on serving the Internet domain name asset class, which he built to 450 customers. He worked at Bear Stearns’ Investment Banking division in their technology/defense mergers and acquisitions team, and was a strategy consultant with Mars & Co in Greenwich. David holds a Harvard MBA and a Yale BA.

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Michael Mayhew, CEO, Integrity Research Panel Moderator

We are the “Greenwich Associates of the research space”. 2.5 years old. We offer research on the securities research industry.

Question for all panelists: What is the most important development in recent years in the research industry, affecting both your business and its clients?

Lisa Shalett, Chairman/CEO, Sanford C. Bernstein & Co., LLC, a subsidiary of Alliance Capital

The biggest development that has changed is the transformation of trading technology; prices have dropped from $1/share (pre-May Day) to a few pennies a share.

What has changed most about the research industry is the valuation of sell side research. The questioning of the value of sell side research is shocking to me, because research really matters; thousands of buyers are voluntarily pulling down our research reports every day on First Call. The question of the value of sell side research is raised by regulatory ambiguity in the bundling of payment processes.

Bundling is preserved as a business practice based on tradition. Transparency should be preserv
ed because it promotes price discovery, and leads to an efficient marketplace. Bundling will continue; what has been mandated is transparency.

Bundling prices creates its own economic efficiencies, allowing one to access excellent resources on a variable cost basis. Although you may not be getting best of breed, you are nonetheless getting execellent resources available at all times.

Managers are taking the high quality of research for granted and lack appreciation for its distribution (their access). The question remains does bundling create economic efficiencies?

David Teten, CEO of Nitron Advisors:

To answer Michael Mayhew‘s question, the biggest trend impacting the research business is that analytical processing power has been commoditized. There are three main drivers of this phenomenon:

– cheaper labor (outsourcing to India, e.g., JP Morgan research)

– dramatic drop in cost of computer processing power

– better data vendors, and better integration of data into our analytical tools

Result: more and more funds have very similar, high-quality analytic tool kits. (Not to mention the profusion of funds, each with those same tools!).

Next logical result: it is exceedingly hard to gain alpha by looking at the exact same publicly filed financial documents as everyone else. Unless you do something different, you will achieve the same results as everyone else, i.e., the index return (less expenses and taxes).

It is mathematically impossible for the average long-only institutional investor to exceed the market indices (post-expenses, let alone post-taxes), because institutions are 90% of volume on most major exchanges. Roughly the same analysis applies to other trading strategies.

The question: how can one gain an edge over the market?

(Time for brief sales pitch). The expert network industry offers an answer to this dilemma. Nitron Advisors provides institutional investors with direct access to frontline industry experts. In particular, we leverage peoples’ digital trail to identify the ideal expert for our clients’ needs. We specialize in executives in transition.

Part of the inspiration for our business: Just as more and more of our social/dating relationships are online, more and more of our business relationships are happening online. Businesspeople are using technologies to build new relationships in the same way that daters use dating sites to meet appropriate partners. More and more people are building a digital trail, and we’re experts in reading that digital trail.

84% of U.S. Internet users have used the Internet to contact or get information from an online group-more than have used the Internet to read news, search for health information, or even to buy something. Bill Gates, John Kerry, and other celebrities are among the over 2 million people currently registered on LinkedIn, a popular business networking site.

(Second and last brief advertisement): In the back of the room are complimentary copies of my new book, The Virtual Handshake: Opening Doors and Closing Deals Online (, with more information about these technologies and our approach.

Doug Atkin, President and CEO of Majestic Research

Majestic Research takes large samples of data, both online and offline, and compiles it into research reports. By utilizing research analysts with a background in applied statistics/mathematics, we provide information that is not traditional on Wall Street. We review 30 million web pages per day, e.g., ebay sales data. Also, half of our work is custom work. We then correlate the data and apply various metrics.

In response to Michael’s question: The preeminent development in the research space is that bulge bracket firms have changed their model. From the perspective of fund managers, bulge brackets are both the largest competitors and customers! The epicenter of buy-side profits is using client data to make money.

The model on Wall Street has always been one revolving around commissions. Those trading commissions are a mask for information. Total cost of trade includes execution cost as well as transaction cost => hard to measure. We estimate buyside loses 1% of performance on each trade, just in commission.

20% of research on Wall Street is valuable, 50% is considered crap, and the rest is marginally valuable. Buy side is outsourcing research and using electronic providers for execution. I foresee sell side becoming a group of large hedge funds-which is what they already essentially are.

Michael Mayhew

Institutional investors traditionally view performance of research recommendations as low on the list of priorities. Why?

Lisa Shalett

1. Ego. No one is going to say, “The reason I’m up 20% this year is because I did what some outside research providers told me to do.”

2. Division of labor in market. Individuals are using 3rd party research for different things, not to buy/sell stocks.

David Teten

I’ve heard clients tell me that they skim everything in a sell-side research report—except the recommendation itself, which they often think is not usefulat all.

Doug Atkin

Fund managers don’t care about buy/sell. They are interested in brokers that provide the access to companies.

I don’t understand this. If you want to talk to a CEO or Investor Relations Representative, simply call them =>if you have some of their stock, or are seriously considering putting significant money to work, they will speak to you!

I think soft dollars should remain, but it must be realized that the money isn’t coming out of the buyside’s bottom line.

Michael Mayhew

Buy side keeps reporting that they are paying in large part for management access. What does this mean for sell side and independent research firms?

Doug Atkin

CIO’s told him at recent conference that they value being able to sit down with C-level management more than anything else. Could this eat away at value of research?

Lisa Shalett

To the contrary, it makes research more valuable and creates a greater need for incremental information, which C-level management can’t provide. Management access simply provides confirmation of already available data.

The buy-side’s obsession with management access is irrational; it’s all about their desire to know what the “consensus” is.

David Teten

Why pay for a five-course meal when you’re only eating the steak?

We’re a biased source to answer that question, given the nature of Nitron Advisors’ business. We think that the buy side’s high valuation on management access implies that they are better off just paying for access to their sources. They shouldn’t be paying more money than they need to for analysis they don’t actually use.

Doug Atkin

“Old Habits Die Hard” => ten years ago, talking to the CEO and hearing what they had to say was value added because they could speak more freely. With Regulation FD, you are speaking to the general counsel. This will take couple of years to play out.

If management access is the “say all and be all”, then Wall Street is merely a concierge service to connect people with C-level management.

Michael Mayhew

What will be the value of research?

Lisa Shalett

The good news is the emergence of independent mutual fund boards, which will raise the issue of management access. You’re trading through a big sell-side bank, and paying $10,000/meeting just to talk with management—is that really logical?

Michael Mayhew

There is a growing demand for proprietary information. Do you think this trend is going to continue? How will it affect the industry?

David Teten

The market only gets more efficient and reflects ever more and ever more quickly the public data. “The beauty of our business at Nitron Advisors is that our business is scalable”. We have access to essentially unlimited sources, each with his/her own unique insights and sources.

By contrast, a traditional research analyst can only provide a high level of value to 10-20 highest-value clients, before his or her insights are too widely disseminated.

Michael Mayhew

If you have more than 20 clients, you can no longer maintain exclusivity.

Doug Atkin

We have syndicated research across multiple sectors that go to 150 customers. If one doesn’t know the new info, that one is at a disadvantage. When we find good data, we sometimes put it up for auction. The top four bidders get it.

Once there is a lot of data available, it can be tailored to meet individual needs. There is a cost to exclusivity.

As the buyside hires more analysts, they’ll consume more outside research.

Michael Mayhew

Fidelity is spending $150 million to dramatically expand their research desk. What’s the implication for everyone else?

Doug Atkin

Fund managers generally subcontract research.

Michael Mayhew

Have these changes in the market changed what you deliver to clients?

Lisa Shalett

Yes, in a negative way. The sell-side is spending a lot of time educating new MBAs/inexperienced analysts. This is not good value-added and creates commoditization.

Must consider the cost of “maintenance research” for that 2nd year MBA, who is not thinking about what to do with underlying security. This is a sub-optimal allocation of resources.

Fidelity cannot hire the 200 smartest people and no longer need the outside world. This is a flawed economic model! Much rather have access to a large pool of outside experts, which will create aggregate value-added.

Michael Mayhew

Moving away from Fidelity, another development that may have more long term consequences, is that the FSA (in UK) has mandated that asset managers have to tell clients how much of their money is spent on research versus execution. What are the implications of this change?

Doug Atkin

Fidelity is the first bulge bracket firm to understand that they have been paying lots of money to research companies to access the same information, while hedge funds pay significantly less. They are subsidizing the smaller players.

Michael Mayhew

You mentioned unbundling => What do you think are the reasons why Fidelity and Lehman are unbundling?

Lisa Shalett

A few reasons:

+ Fidelity could do this partly because of their unique ownership structure (family, not public company or partnership like the other top 20 managers). They wanted to move towards hard dollars.

+ Fidelity also knew that it was going to face more scrutiny from independent mutual fund boards.

+ Regarding Lehman, it is clear that they had an underleveraged proprietary trading opportunity and wanted to build a proprietary desk—leveraging Fidelity’s volume and the information they could learn from Fidelity. They were trailing the bulge bracket in prop trading.

Doug Atkin

Fidelity also did this move for dwarf-related reasons. (industry joke)

David Teten

There are macroeconomic trends towards unbundling, simply because it’s better for the retail investors—the widows and orphans whom the money managers are in theory supposed to be working for. However, there is tremendous inertia preventing change. A lot of people make a lot of money from the existing ecosystem.

Given the move towards hard dollars, the total research budget probably won’t change that much (although it could shrink). However, the allocation will change dramatically. A lot of sell-side research is simply not worth much, but there is no price signal in the market to tell that fact to the sell side.

Michael Mayhew

Fidelity is attempting to reduce competition by raising the cost structure. This will hurt investors.

David Teten

Middle sized managers should consider taking the lead with a move towards ha
rd dollars. This creates more value for clients, and is a powerful differentiator in marketing. In David Swensen’s (Chief Investment Officer of Yale) new book, Unconventional Success, he specifically endorses a few fund companies that he believes align manager interests with investor interests. Wouldn’t your company also like to be endorsed by David Swensen?

Michael Mayhew

Has Regulation FD improved the situation for investors?

Lisa Shalett

No, it has created a communications barrier. Unintended consequences have resulted, similar to everything else the regulators have ever done. It makes management much more scripted.

Doug Atkin:

We use technology to (metaphorically) stand outside the Applebee’s store and analyze their foot traffic.

Michael Mayhew

Performance of sell-side research has noticeably improved.

Lisa Shalett

Since 2000 => 100% better results => the bar has been raised in sell-side research.


Scott Lichtman

Regulation and innovation has raised the bar on research. What are best practices for valuing ROI on research?

Michael Mayhew

Growing number of people are concerned about rigorous process in valuing research if the client will learn the cost of unbundling research.

Lisa Shalett

Traditional payment mechanisms put payment in the eye of the beholder. We are willing to be price-takers; we believe in the value of our product.

“Beauty is in the eye of the beholder” => that’s how people evaluate research

David Teten

Amount of time talking with a source is a possible (very rough) proxy in valuing research. That proxy could theoretically be used for both traditional research analysts as well as for industry sources.

Doug Atkin

Two bizarre practices in this industry:

– We give stuff away.

– Consumer says what it’s worth long after the product has been consumed.

This bizarre system only works because the buy side is playing with Other Peoples’ Money.

This is comparable to purchasing a plasma screen from Best Buy, and determining how much you will pay a year later!

David Teten

Counterintuitively, I recently read a Harvard study which found that “Analysts at firms with underwriting and trading businesses are actually less optimistic than those at pure brokerage houses, who perform no underwriting. The relatively less optimistic forecasts for underwriting firms are not fully explained by bank reputation. Nor is the relative optimism of brokerage firms explained by the types of clients they serve (retail or institutional). We conclude that sales and trading activities used to fund research create strong incentives for analyst optimism.”

Or in plain English: Anyone who is a broker-dealer has a strong motivation to get you to trade, regardless of whether or not it’s in your interest. This is exactly the same conflict of interest that has motivated much of the retail brokerage industry to move away from trade-based payment to wrap fee accounts (in which the broker is paid on a percentage of assets basis.)

Maybe the best advice you’ll hear this week is to ‘Hold’ Google. Don’t sell, don’t buy—just sit there with your position. But one of the many conflicts of interest that soft dollars create is that you don’t have a ready way to pay an analyst to tell you that—and the analyst is highly motivated not to tell you to Hold.

Michael Mayhew

Problem: Too much supply of research. By placing value, we will let the market erase the inefficiencies.

One portfolio manager I know says that he gets 500 emails/day, and 100 calls/day, and most of them are research of various sorts.

Doug Atkin

If Wall Street were actually using their own money, they wouldn’t allow for such inefficiencies. 20% Wall Street research is great. 10% independent research is great; just because it’s indie doesn’t mean it’s good. There are 450 independent research providers in North America—most of them are not very good.

Lisa Shalett

There’s a fear of a bulge bracket conspiracy. It’s not in anyone’s interest to make equities market look like the fixed income market. Hopefully, technology will prevent this from happening.

Question from audience (older HBS graduate)

What’s your advice for the retail investor on how to make sense of all the research out there?

David Teten

Almost every neutral academic observer will tell you that retail investors should not buy individual securities; you should buy funds. New HBS graduates often assume that they’re brilliant stock market investors, but you’ve probably been out a few years and seen that the degree does not necessarily grant you investing acumen.

Unless you made your retirement money by investing in securities, then you probably don’t have the training to be a successful professional investor. You’re much better off with funds.

Regulation FD was based on the idea of leveling the playing field between retail investors and institutions. This is nonsense; you will never level the playing field between retail investors and institutions. it was a poor answer to a question that no one was asking.

Lisa Shalett:

I agree with David and take it one step further: in most cases, you should be investing in index funds. Actual usage of the much-hyped research settlement is paltry. The individual investor already has far too much information, but doesn’t know what to do with it.

Gautam Ramchandani (Harvard Business School Club Officer)

Thank you all for coming! I hope to see you at our upcoming 5/18 Hedge Fund event, which will feature many of the brightest luminaries in the hedge fund world. See our site,, for details.

(David Teten’s slides for his presentation are available on request by mailing info @ . Image via Wikipedia)

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