Magazine

Research Revolution


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


Soul Searcher
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