In the wake of recent corporate scandals involving Wall Street analysts, more fund managers may begin using their own in-house research to pick stocks.
Some Wall Street analysts have been accused in recent months of issuing favorable reports about certain stocks in order to strengthen their firms' business relationships. For instance, well-known tech stock analyst Jack Grubman resigned from Salomon Smith Barney, of New York, after critics accused him of giving companies favorable ratings as a reward for granting Salomon their investment banking business.
Since then, the scandals have raised serious concerns about the potential conflicts of interest that pervade the world of analysts.
Post-Enron Research At Fund Complexes
Will fund companies now turn a cold shoulder to potentially tainted analysis? Some in the industry think so. In fact, fund companies are doing more of their own research in house.
"For investment managers to adjust, they're going to have to go back and do the fundamental analysis the way it should be done and not rely on Wall Street analysts," said Mark Foster, who manages the Kirr Marbach Partners Value Fund for Kirr, Marbach & Co. in Columbus, Ind.
Foster, whose firm conducts its own research, said he never trusted popular securities analysts, even before they became embroiled in controversy. "I think there are a lot of things you can do that Wall Street isn't doing today to evaluate a company," he said, adding that much of the research coming out of Wall Street is "not quality."
Quoc Tran, a research analyst at Weitz Funds, of Omaha, Neb., which also analyzes its own stocks, called the move to in-house research "a shift back to basics," and said that "revelations about tainted analysts" could cause fund managers to turn to more proven, reliable methods.
"I can't see how you can have a competitive advantage if you don't" use proprietary research, he said.
To be sure, it has never been uncommon for investment companies, especially large firms such as Janus, to favor their own research over that of Wall Street securities analysts, said Emily Hall, an analyst at Morningstar of Chicago. Likewise, observers said that many firms employ both proprietary and so-called "Street" research in concert, often using information from an external analyst if they pick up on a tidbit of news that a fund manager had not yet discovered.
But Foster, who has been an investment manager for more than two decades, said that there was a time when Wall Street analysts rarely enjoyed such a high profile. The stock boom of the late 1990s changed that, he said.
"In the early years, you had Wall Street putting out research, but not near to the level that you have today. The whole thing has changed," Foster said. "You had this huge bull market that not only got more investors interested, but raised the visibility of the business. When the market's going up 20% every year, you get a little lazy and you tend to rely on the Street. That's not how it's supposed to work."
Now, Foster said, fund companies will be driven to do their own analysis because, even after the scandals, Wall Street analysts won't likely change. "The Street will attempt to make a change, but it will be superficial because those [merger and acquisition] dollars will still be out there," Foster said.
Still, Josh Brooks, the chief investment officer for value funds at Delaware Investments in Philadelphia, said that making the switch from relying on Wall Street research to proprietary analysis could prove difficult.
"It's expensive," he said, and "it requires a significant amount of skill and diligence."
"I wouldn't be surprised to see a move toward more internal research," Brooks continued, "but it's a question of whether people can do that well."
Not on the Money
Naturally, fund managers who do their own analysis don't always produce stellar returns. For example, the $29 million Kirr Marbach Partners Value Fund has posted year-to-date returns of negative 13.4%. And two value funds that Weitz Funds oversees, the $3 billion Weitz Partners Value Fund and the $4.3 billion Weitz Value Fund, have posted year-to-date returns of negative 18.5% and minus 18.27% respectively, according to Morningstar.
By comparison, all domestic equity funds have posted year-to-date returns of a negative 16.61%, Morningstar said.
"We got hit across the board," Foster said of his fund's performance, adding that his strategy this summer has been to "own things that are going down less."
But Foster would still rather bet on his own homework than Wall Street ratings. He said analysts aren't doing enough to determine the true condition of a company before they recommend it. The problem, he said, is that many analysts look primarily at a company's multiple, which is an exponential projection of the company's future value, even though there are other factors that can shed better light on a stock's worth.
For example, Foster said his firm examines the quality of a company's managers. "Are they builders of value, or are they destroyers of value?" he asked. The firm also monitors trends in mergers and acquisitions when picking stocks because sales of companies provide benchmarks for the value of other firms within the same sector, he said.
Value-to-sale ratios, which are based on a company's expected sales revenues, are also a handy metric because they are more difficult for companies to manipulate, Foster said. In contrast, it is far easier, he said, for companies to skew their earnings reports.
Lastly, the firm considers value-to-cash flow ratios, which examine the amount of cash that a company has to spend. The ratio is an important barometer, Foster said, because a firm with freely available cash has more options, such as acquiring competitors or paying down debt, both of which can increase a stock's value.