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Research Revolution
FEBRUARY 3, 2003
BUSINESSWEEK INVESTOR
Six top stock-research firms--all free
of investment-banking pressures--are banding together while retaining
their unique spins
You know those lengthy analyst reports your broker
gives you, the ones that always scream "buy" on the cover. Get
ready for some that say "sell." As part of the settlement with
New York State Attorney General Eliot Spitzer, big Wall Street houses
will have to supply clients with stock reports from at least three independent
research firms to supplement their own. And such firms, free of investment-banking
conflicts, are more likely to dole out sell recommendations.
Which independents will the brokers hire? One likely candidate is Best
Independent Research (BIR) , a new consortium of six independent
research firms formed in December. Since many independents are small operations,
often with just a handful of employees, Thomas White, president of BIR,
thinks banding together will give the group the leverage it needs to attract
brokerage clients. Until this point, BIR's firms have sold their research
exclusively to professional money managers for upwards of $10,000 a year.
The wirehouses should announce which research firms they'll be working
with in the next six months, White says.
QUANTS RULE
White has been careful in selecting his group's members. Using a database
created by Investars , a company that tracks the performance
of research firms' stock picks, White chose only firms that cover at least
500 stocks and that ranked in the top group as a result of their buy and
sell ratings. (Investars considers a sell rating as a short position for
performance purposes.)
The breadth of stock coverage was as important as performance. "If
you're going to distribute your research to Merrill Lynch ( MER
), you can't cover only 30 stocks," says Kei Kianpoor, Investars'
chief executive. "You've got to offer your opinion for each stock
Merrill covers." Investars tracks 140 research firms, but only 30
cover more than 500 stocks. All six BIR members rank in the top 10 in
this group over the past year for their stocks' returns and the top 15
over the past three years. During these two time periods, no major brokerage
house beat any BIR firm, and the only independent to have a performance
edge was Standard & Poor's (like BusinessWeek , a division
of The McGraw-Hill Companies), which held both No. 1 slots.
Because of their small staffs, BIRs all use computerized quantitative
analysis to rate thousands of stocks. At White's firm, Chicago-based Global
Capital Institute , his analysts emphasize sectors in their ratings,
examining different statistics for a company depending on its industry
group. With retail stocks, for instance, they screen for strong balance
sheets with little debt. "The retail sector has produced more bankruptcies
than any other sector in the past 100 years," says White. Too much
debt and fickle consumers are the main reasons. Among retailers, White
favors Abercrombie & Fitch ( ANF
) because it has no long-term debt and has plenty of cash on its
balance sheet. He dislikes Kohl's ( KSS
) because its earnings growth has become dependent on debt and equity
issuance.
Another BIR firm, Colorado Springs-based Columbine Capital Services
, employs a sector model as well, but with a twist. While White's
analysts focus mainly on stats relating to a company's fundamentals, such
as its valuation and earnings growth, Columbine adds analysis of a company's
stock-price movements, or "price momentum."
Depending on the historical behavior of a sector, the firm will weight
price momentum more or less heavily in its stock ratings. With the tech
sector, price and earnings momentum have been more significant predictors
of future performance than valuation stats. So even though software maker
Oracle ( ORCL )
is pricey, the firm rates it a buy because Wall Street analysts keep revising
their earnings estimates upward, and its stock is outrunning other software
makers'. Since valuation is a better indicator for media companies, Columbine
also rates troubled Vivendi Universal ( V
) a buy.
VARIATIONS ON THEMES
Three of the other BIR firms, Ford Equity Research, Callard Asset
Management , and Channel Trend , employ variations
on these themes. Ford Equity also uses earnings momentum, price momentum,
and valuation to rank stocks, but unlike Columbine, does not change the
weightings to suit the sector. Callard has two separate rating systems
based on valuation and price momentum. BIR currently distributes only
its price-momentum system. Channel Trend's Price Projector Model uses
price momentum and something called "reversal-to-the-mean" analysis.
It is precisely these variations that make each firm unique. For instance,
though Callard generally looks for stocks with positive price momentum,
it switches gears when market volatility is high. Then it searches for
laggards. "High volatility levels often indicate a trough in a bear
market," says Ricardo Bekin, Callard's chief information officer.
"That's when stocks that have been beaten down the most snap back."
Channel Trend also looks for market outperformers, but in a different
way. A stock can earn a buy rating if it's rising from a low point heading
toward its average price--or, reverting to the mean--for the past 200
days.
All five of these firms rank stocks on a continuous scale on their relative
attractiveness to each other, so there will always be a certain percentage
of buys, holds, and sells. The sixth firm, Seattle-based Market
Profile Theorems , looks at the overall attractiveness of the
entire market as well as individual stocks. So there are times that it
will have no buys or no sells if the market looks particularly bad or
good. In addition to valuation and momentum measures, the firm studies
the trading of insiders working at companies to see if they are buying
or selling shares (BW--Oct. 7). These insiders often act as a "contrarian
indicator" when the market has beaten down or overvalued a stock,
says research director Michael Painchaud.
White's ultimate goal for BIR is to have all six firms' research distributed
as a package to brokers. Brokers and their clients will use BIR's Web
site, Bestindependentresearch.com
, to examine how each firm's ratings performed for any stock the group
covers and compare it with the broker's track record with the stock. That
way, the client will be able to choose the rating from the firm that has
the best record with, say, Intel ( INTC
) or Microsoft ( MSFT
).
Will independent research from BIR and others change investors' fortunes?
Not necessarily. There are a lot more factors that go into successful
investing than a buy recommendation. Still, investors who act on these
ratings can have some assurance that those who issue them have their interests
at heart.
By Lewis Braham
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