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April 1, 2004

Skies Open for Independents

By Andrew Klein

Forget about conflicts of interests, scandals, IPO abuses, tech crashes and more regulation. It is the best of times for independent research analysts. The analysts' job has changed irrevocably - some say for the better - with the adoption of Regulation FD (Reg FD). But this rosy outlook comes with some caveats. The job of producing these research insights will be harder. That's even though recent activity suggests that portfolio managers increasingly depend on the original,

unbiased insights that give them a competitive edge.

Reg FD stopped the common practice of companies selectively leaking news and information to research analysts before the broader marketplace. That forced analysts to take more proactive, investigative roles. They had to actually talk to customers, suppliers and industry experts as well as perform their own channel checks to generate ideas and advice. The rule returned the analyst to traditional roots.

This is a far cry from what was done through the recent salad years. The banking boom of the last bull market created a climate in which analysts weren't measured as rigorously as they are today. Many of these analysts came to the job straight out of business school and succeeded by studying balance sheets, income statements and earnings calls.

In future, however, we'll see more of the old-school types who became analysts after years of industry-specific work. There will be fewer business school analysts. These old-school analysts will have deep sector and industry expertise - even operating expertise - and a wealth of contacts. Their focus will be on solid, old-fashioned detective work that utilizes investigative skills and knowledge gained from experience rather than books. It's not a job for everyone, but the realities will weed out those not up to the rigorous work required.

Those up for the challenges can expect some extraordinary opportunities this year. It may seem somewhat counterintuitive, but the continuing cutbacks in research by bulge-bracket firms open up a wealth of opportunities.

As research budgets were slashed from an average of $1 billion in 2001, to about $300 million last year, there has been a parallel drop in the number of companies covered: from some 2,000 to about 600. As a result, most bulge-bracket investment banks have been focusing on the large-cap stocks that constitute their primary investment banking relationships. This has created an enormous opportunity for analysts.

Firstly, there are now many large institutional investors holding stocks no longer covered by research. Secondly, a great many of those uncovered stocks are significant companies: not micro-cap companies with $30 million to $50 million-market caps, but $500 million to $2 billion market-cap companies. Portfolio managers are paying for research on these overlooked companies and will continue to do so.

The next emerging opportunity is also exciting. The need for objective, independent advice will foster a focus on evaluating, analyzing and talking about companies in the process of public offerings. The benefit of doing so is obvious.

For an analyst in the semi-conductor space, for example, it's a good exercise to stay in touch with the venture-backed companies that might be going public. That's because, if nothing else, the analyst is going to learn a lot about the sector. And, if the analyst happens to get it right, he or she will get commissions from those trying to figure out how much, if any, of the offering to buy.

Finally, Europe presents another untapped opportunity for the independent analyst. European portfolios have a higher percentage of U.S. equities than ever before.

Indeed, the number of analysts spending time marketing in Europe, and the number of salespeople covering these accounts, has declined significantly. It is, indeed, the perfect storm in the world of independent research.

Andrew Klein is Chairman and CEO of Soleil Securities Group. The firm provides institutional investors with equity research. It uses independent research analysts and boutiques.