Overpaying for Damaged Goods

Thomas K. Brown is no shrinking violet. A star sell-side analyst, now 41 years old, he was fired from Donaldson, Lufkin & Jenrette in 1998 because, he says, he refused to kowtow to the firm's investment bankers. And he remains a harsh critic of his former sell-side colleagues throughout the industry. Now he's a buy-side analyst, heading his own investment management firm, Second Curve Capital LLC, and already he utters unkind words about the buy-side. Too many institutional investors can't distinguish good analysis from bad, he says, and if they do recognize good research, most are unwilling to pay for it. Below are excerpts from an interview Brown held with Robert A. Bennett, editor-in-chief of U.S. Banker:USB: What I'd like to talk about today is the issue of sell-side analysts--their quality, where the business is going and the pressures of the marketplace.BROWN: In the Seventies, equity analysts did in-depth research of an industry and published reports of their findings--they didn't necessarily have investment conclusions. If you wanted to know about DuPont, or if you wanted to know about the chemical industry, you learned about the details of the company and the industry from sell-side research. And that's what Donaldson, Lufkin & Jenrette was founded for: It provided in-depth, high-quality research to institutions, for which they'd pay.USB:USB:They paid by buying stocks through DLJ?BROWN: Right. Then in the Eighties, the role of the analyst shifted and the buy-side said, "We want investment opinions; we want this research to lead to a conclusion." And so it wasn't enough just to write those in-depth reports and be knowledgeable about the industry--you had to have a rationale for picking stocks. And there were some analysts, then, that got weeded out through that process. They couldn't draw a conclusion, an investment conclusion.In addition, in the Eighties, the analyst became a marketer. In the Seventies, you didn't have to spend a lot of time marketing your research. Your sales force did that, and the product marketed itself. In the Eighties, because of the proliferation of analysts and product, you needed to cut through the clutter and, therefore, you had to become a marketer, making about 100 phone calls a month to clients. Well, that took away from research. So a big chunk of your time as an analyst went to marketing. In the Nineties, the next evolution of the analyst was to really become the investment banker. The reason for the shift was purely economic. Institutions every year were lowering the average commission that they paid per trade, and the amount of profit being generated from equity research was very little at any firm. But there was a lot of money being made in investment banking, whether that be secondary offerings, initial public offerings, or M&A activity--advisory work--and the analyst became instrumental in getting that business.Therefore, the true research time that an analyst has is very little, because they're spending all their time working with the investment bankers. And when they're not doing that, they're out marketing to try to become an Institutional Investor-rated analyst. Yet, they're still viewed by the image of the 1970s analyst, who knew the industry better than anybody else. The reality is that most sell-side analysts don't know the industry at all. Their industry knowledge is embarrassing.USB: Isn't that, to some degree, the fault of the buy-side? They are under pressures of their own.BROWN: It is the fault of both the buy-side and the media.USB: You're blaming us?BROWN: Let's start with the media. The daily media needs a quote. Wachovia announces its earnings, and journalists need to quote some expert on the earnings. So the daily media is just getting anybody they can, and they go to the sell-side and quote them as experts. We need the media to hold some of these analysts accountable, because when they do, they'll realize that we shouldn't be quoting this person because he or she really doesn't know what they're talking about. History will show that they're just not right most of the time.But the most important change has got to come from us, the buy-side. If we're only willing to pay five cents a share in the secondary market, instead of the 60 cents they get from underwriting, Wall Street is going to continue to devote its attention to the 60-cent-a-share business and not to the five-cent-a-share business. So we've got to disaggregate the commission dollars we pay. Right now, when we pay a commission, it covers trading execution, it covers research, and it covers capital commitment, and it covers trying to generate enough business at a firm to get their attention in initial public and secondary offerings.USB: Isn't part of the problem that buy-siders have to sate the market's lust for quick profits, and that more than ever this is based on ignorance? BROWN: Right. In the 20 years that I've been in the business, money managers, as a group, have become much more short-term oriented in both their thinking and their acting. And over that time period, of course, money managers have continuously underperformed the indexes. So when I study the greatest investors of our lifetime, I find very few--there are some, but very few--that achieved outstanding results as a result of short-term trading activity. So I think that in the money management business, we've got a lot more money managers than we have good money managers.USB: Haven't good money managers gotten clobbered even if they've been right over the long-term? It seems to me the problem is the entire system.BROWN: I don't think so. If you invest for the long-term and you're good, I think you will achieve great results. It's when you try to chase your tail--which so many people are doing, since they're so worried about the money being taken away from them because of a poor quarter's-worth of performance--that I think the results turn out to be poor for both the short-term and the long-term.USB: Where does the cost of 60 cents a share come from?BROWN: It comes out of the fund's performance. The irony of the 60-cent versus five-cent cost is that I pay zero for a share of a secondary or IPO. Or, I should say, it looks like I pay zero. If a company you invest in raises a dollar, they get only 94 cents. The other six cents goes for the underwriting.And so on my books, buying IPOs and secondaries will help my performance in the sense that it looks like I'm not paying that commission. That commission is a deduction from what the company receives. In some ways you say you're not paying a commission, but you are as the owner of the company. So if you're buying shares in the company, you can't look on it and say, "I'm not paying any commission," because you are.USB: What you seem to be saying is that companies are paying excessively high fees for the underwriting.BROWN: Right. Until recently, there has been surprisingly little competitive pressure on IPO underwriting fees. But that has begun to change.USB: But there's nothing you can do about that.BROWN: No. What I need to do is put pressure on the company that I own rather than rent. This ties to your point about the short-term mentality. We don't have enough shareholders who think that they are truly owners; they're really just renting the shares. So I need to think like an owner and say to my company, "That 7% IPO fee is too high. Negotiate that down with Goldman Sachs." Or let's use an online system where maybe there's a 2% fee rather than a 7% fee.USB: Do you really get that much more for your money when Goldman manages a deal and charges its huge fees?BROWN: It's the worst in the advisory area. I would say, having been on the sell-side and seen the fees that these firms generate--particularly in the financial services arena--and the effort extended, that the amount that companies pay for M&A advisory work is outrageous.USB: Then why is there is no opposition to it?BROWN: The CEO wants to buy another bank, and his board wants to feel good about that decision. So what they do is they hire a major investment bank to make them feel good about it.USB: So it is all marketing?BROWN: It's all image.USB: Don't you think that's what financial services is coming down to? Banking is hardly banking anymore. It's how to sell a credit card through direct mail. I've been in this business 40 years, and it has deteriorated to selling toothpaste.BROWN: Well, I think that's what you get in an industry that basically sells commodity products and has excess capacity. McDonald's sells a commodity, its hamburger; it sells because it is a good marketing company. And I think that's true for any financial services company--that if you're going to be successful, it's going to be because you are a successful marketer.USB: So basically you're saying people are being lured into paying more than they have to by the same kind of glitz that sells regular consumer products.BROWN: Yes, and maybe there's another element to this: There's the business of operating a financial services company and there's a business of acquiring somebody else's financial services company. My experience is that most CEOs enjoy the latter more than the former. There's an ego aspect to pursuing and then winning a chase, in terms of an acquisition.That's why I propose term limits for CEOs. What I find is that if you're a CEO for more than 10 years, your interest in truly understanding and managing the business goes down, and your interest in politics and being part of the ABA and doing acquisitions goes up. That's more glamorous.I'd rather see boards turn their CEOs over more. There are all sorts of exceptions. You could point to great CEOs that would have been ousted based on my term limit rule, but you can also look at a lot today that shouldn't be there.USB: Where would you put Sandy Weill?BROWN: I would put him in the exception, together with Jack Welch at GE. They're great examples of outstanding CEOs. But for every outstanding one, I can give you six that really should have left.USB: You want to name some?BROWN: No.USB: Is there a solution?BROWN: We've got to disaggregate what we're paying for. Today, the five-cents-a-share we're paying includes trading execution, research capital commitment and access to IPO activity. The buy-side has really got to figure out what we want to pay for and how much we want to pay for it.Then we will start to recognize that the vast majority of Wall Street research is worthless. Phil Duff, the chief operating officer at Tiger Management--who was the CFO at Morgan Stanley--used to say that the best 2% of research on Wall Street is priceless, but by the time you get to the middle 50%, it's worthless. I agree.USB: I guess you're saying that many analysts today are worthless, as well.BROWN: So many of these people are getting paid seven figures, and all they're doing is reporting what the company wants them to report. The value they add isn't great enough to support their compensation for long. So eventually it will change.USB: How will it change?BROWN: New vendors will pop up that will provide objective, insightful, unbiased research. Right now, the buy-side is paying way too much to the sell-side for "research."USB: And they're really not getting research.BROWN: No, investors are getting a lot of paper, they're getting a lot of commentary--whether it be physical paper or digitized paper. But it's not research, it's reporting.USB: Do you think that most buy-siders know what they're getting? Do they know what the research is?BROWN: Unfortunately, the answer to that is no. And that's why I've been trying to be the poster person for trying to awake people as to how bad Wall Street research is, and expose the pressures on the analysts. DLJ fired the number one-rated regional bank analyst because 23 investment bankers said his opinions were going to hurt their M&A business. So there's a firm that clearly said it's much more important for us to have an analyst that's going to help us in the investment banking business than have an analyst that's going to help us in our institutional/retail acquisition business. And from a firm's standpoint, that's a good business decision. And until the buy-side wakes up, that is going to be a good business decision.USB: Do you see any hope that they'll wake up?BROWN: Yes, I do. In the last 12 months there has been much more written about it, including this week's Wall Street Journal story about the Goldman Sachs analyst. You know, he published a report about who the survivors are going to be, and all the survivors are going to be Goldman Sachs clients, and all the companies that aren't are going to be aren't. And he got called on it. The buy-side still doesn't know enough to be able to ferret out why that report was written. And I think stories like the one you're working on, stories like the Journal's, are helping to flush this issue out.USB: You've attacked DLJ on your Web site (www.bankstocks.com). Do you think that it might create a sense that it's sour grapes?BROWN: It might, but that would be a mistake. You know, in my career I've always been sort of on the edge. I did that because I was willing to be held accountable. I was the only analyst on Wall Street that actually published the performance of his recommendations. So I've done things that are very vocal, they're loud, they're visible. Sometimes people object to them, but I'm trying to make a difference--and, actually, I'm trying to get action.