Whither Research?

My friend and former colleague Seth Goldstein got front page billing last friday in the Wall Street Journal. Seth's company, Majestic Research, offers a new form of stock research that is totally independent and proprietary. It makes money for its customers by giving them data they can't and won't get elsewhere. The term for companies like Seth's is "third party research providers", meaning that the trading ideas don't come from the "sell side" or the "buy side", they come from a third party to the transaction. In reality, many of the new emerging research providers are really sell side players of a new and different flavor.

Who else is in this business? Interestingly, Jack Hidary and Stanton Green's Vista Research and Andy Klein's Soleil Group are two important new players. Then there are two of the veterans of this business Gerson Lehrman Group and CFRA.

Seth Goldstein, Jack Hidary, and Andy Klein are veteran entrepreneurs who formed and built Site Specific, Earthweb, and Wit Capital, respectively. What do they see in the independent research market that takes them here instead of some other attractive emerging market? And what about Gerson Lehrman and CFRA? Well Bessemer Ventures just led a very large investment in Gerson Lehrman and last fall TA Associates invested $60 million into CFRA. Something big must be going on here for all of this venture/entrepreneurial activity to be happening in this sector.

As Jim Cramer (who has his own third party research group called IRG at TheStreet.com) points out in this week's New York Magazine, traditional equity research from the large brokers just stinks. It's awful and getting worse.

It's pretty clear to me that just like the computer industry in the late 80s and 90s, and the telecommunications industry today, the brokerage business is beginning to undergo a transition from a vertically integrated model dominated by large monolithic companies to a horizontally layered model with leading providers dominating each layer, but nobody dominating more than one layer at a time.

Who is going to be the Microsoft/Intel/Cisco of equity research? Who knows? It could be one of the companies I just mentioned or it could be a large broker who decides to jetison all the other layers and focus on research (but i doubt it). But one thing is clear. It's a great time to invest in companies that will accelerate this process of decomposition and recomposition and a lot of value will be transferred in the process.

I want to invest in this trend and plan to post a lot more about this emerging category in the coming weeks and months.

Comments

[Dan Malven]

The dilemma faced by these companies, which may or may not be a structural impediment to them getting big and providing a venture-like return (not sure about this yet), is the law of diminishing returns. In the IT industry, a new economic principle was formed: the law of increasing returns, i.e. the more people used Windows the more valuable Windows became to the next buyer. Equity research has a severe law of diminishing returns, i.e. if 1 person has proprietary information it is incredibly valuable, if 2 people have it it is less valuable, and it quickly goes to worthless the more people have the information. It makes it difficult to scale equity research businesses. I hope Seth cracks that code, but I'm afraid its going to be a tough one to crack.

[chervokas]

What I wanna know is how the hell does Seth, who once described his career path to me as failing his way to the top, keep getting A1 WSJ stories written about him!

[chervokas]

Actually I shouldn't be so flip. Just before all the shit hit the fan w/Spitzer and the brokerage houses I was being recruited for an analyst job at Bernstein, which had a rep for independence since it was unaffiliated w/ any sell side operation. The gig was number 2 media tech analyst.

I didn't get the job. Maybe I wasn't ready for it, but that wasn't why I didn't get it. I didn't get the gig because I was different....a journalist, entrepreneur and make believe VC w/o an MBA. The recruiter and I kinda hit it off and we talked honestly. I had hired people I told him, I understood the situtation. If they hired me and I sucked, well, that would look bad. If they hired someone from HBS who sucked, well, hell how did they how, the cat had a Harvard MBA! CYA baby, yeah!

There's a culture problem on Wall Street when it comes to thinking outside the box. Its a stepford wife kinda culture...look the same, do the same things, go to the same schools and clubs, think the same way, sell each other financial instruments and companies.

I'm actually a pretty good media technology analyst, as it turns out. But not necessarily a good equity analyst. Why? Because I agree w/ Seth's company's apparent premise that the future performance of industries and companies is best analyzed from end users up. Especially in media and technology, which are my bag (and Seth's btw). People adopt technologies in response to specific behavioral concerns about what's helpful or fun vs. what's too expensive or what's just too damn difficult; and macro-demographics are predictable constants that drive opportunity in the media business.

But this is an entrepreneur's way of looking at things: to seek opportunity. An investor's way of looking at things is to reduce risk.

Anyway, just as the value of shares in public companies has become increasingly detached from the cash flows and profits of those companies, so has equity research become increasingly detached from analysis of the operating businesses.

Part of this is because the financing of business has become increasingly abstracted from sales--w/ securitized debt and increasingly sophisticated derivatives and currency swaps. But part of it is because the end users of equity research--buyers of stocks--have responded to this environment by making purchases based on criteria other than how well a company can legitimately be expected to perform next quarter.

If, in fact, a new kind of investor, enabled by internet technology can, as a class, begin to effect markets in ways that are at least comparable to, say, the California teachers retirement fund, and they are looking for a new kind of research, then maybe there's an opportunity there.

But that may be a bigger set of "ifs" than the yankee pitching staff.

[seth goldstein]

seems like we have a good dinner conversation going now. fred, dan, jason, thanks for taking the time to raise these issues, all of them important. a couple things we would seem to agree upon:

1) equity research is changing in fundamental ways.

2) the trading activities of the buy side and of hedge funds in particular are disproportionately influencing these changes.

3) as dan so eloquently points out, there is a natural dimunition in research value as more and more funds get access to the same research and such research becomes commoditized

4) at the same time however, the inverse holds that the value of custom, proprietary, private research increases greatly for each indidvidual fund (or in some cases individual managers within a fund) as they are forced to compete against passive low cost index funds

5) net net, the question is whether a research firm can scale its business (as a traditional vc would require) while at the same time providing customized products. this is precisely what we are working on at majestic, and what i understand a number of other firms are working on as well (notably our older brother www.glgroup.com).

6) jason claims that "equity research become increasingly detached from analysis of the operating businesses." i am not sure i agree with this, as i think the big breakthrough that fred refers to and which the wsj tried to tease out was that the most innovative forms of investment research are trying to track changes in a company or a sector's fundamentals at their very source, as opposed to in a derivative fashion through management calls, consensus expectations, and even so called experts. majestic believes that it is impossible to study companies and understand the trends that are impacting their performance without having real visibility into how the demand for their products (across multiple sectors) has become intermediated by real-time information flows: internet browsing, credit card transactions, prescription refills, auto registrations, etc. the internet specifically and information technology in general have changed the way companies do business, and now investment research must interpret these changes in a context that is absolutely fluent with these catalysts.

7) as a painful and pained red sox fan i have ZERO empathy for your worries about the yankees pitching staff. you want pedro, go ahead. take him. take schilling as well. hell, even my son jacob throws a nice fastball for a 5 year old. why dont you take all the players in the entire league and simply play multiple yankess lineups against eachother. its the same kind of self inflated bubble that seems to be affecting the new york financial industry not to mention its real estate market.

[Frank Ruscica]

IMHO, a key to scaling will be repurposing for in-house corporate strategists, career services offices at professional schools, etc.

[Frank Ruscica]

Also, isn't there a risk that these firms would be disintermediated by a prediction market (via simulated portfolios) that makes it plain who are the best analysts?

Transparency serves the star analysts, after all...

Of course, this precludes scaling issues for the firm...

But does make scaling the prediction market a portentous play...

[chervokas]

Seth, I do very much agree with you about the opportunity for private research on behalf of hedge funds. W/ the growing consolidation of so much wealthy in the hands of such a small number of people, the virtually unregulated pooled investing funds---both venture and hedge--are increasingly interesting in every way.

But you know, at least those VCs are cheap bastards....they hate to pay for anything!

[Stephen]

These are interesting businesses but one has to ask HOW most of their revenues come through the door. I would bet the answer is mostly through soft dollars. If I were an investor, I would pay close attention to the scrutiny the "soft" dollar is getting from the SEC and see if the customers transfer to a non-soft dollar environment.

This has nothing to do with their value as a service, which i think is high.

[Gen Kanai]

Does anyone know if Japan has any third party research providers? I'd be interested in any similar trends here in Asia/Tokyo.

[Druce Vertes]

The research side is where trading was 5 years ago before FIX was launched.

Now the trading/STP side is loaded with hot companies like Javelin (standard FIX platform/APIs), Lava Trading (ASP middleware platform to connect to every broker/ECN liquidity pool), Charles River Technology, Eze Castle (front ends).

If research follows a similar path, substituting RSS for FIX, you need 1) the standard, 2) a platform implementing a standard, 3) ASP or central search/filtering nexus, and finally clients for publishing/reading/email/wireless integration etc. You need key players to take the role Fidelity and Salomon took to move FIX forward.

It's a small enough space that one company could possibly do all of them, but the best business opportunity seems to be the ASP/search engine nexus.

[Nick Hutton]

I am part of a similar firm providing evidence-based research specifically on the IP services sector including carriers, managed service providers, software, and equipment vendors. We regularly publish some data freely on the site: here.

Nick