Prudential Securities is dismantling its investment banking operations and scaling back on IPOs so its research analysts can be more objective, more investor-focused.
When the move was announced in December, CEO John Strangfeld said the firm wants to provide research that doesn't serve two masters: investors and issuers.
Prudential Securities President Jamie Price offers some observations about the firm's new research philosophy, the changing nature of research, and what this means for retail brokers and clients.
RR: First, why have research analysts been getting such bad press lately for the conflicts they face when they're involved in a firm's investment banking operations?
Price: I don't think you can pin it on any specific thing, but there are two broad themes.
I think everybody, including our firm, strayed away from real fundamental analysis of both the market and certainly technology stocks. Analysts were saying that the fundamental ways of analyzing a company and the prospects for that company had changed. It's a new economy. It's new this, new that.
The second thing that happened at the same time was a record number of new issues and a huge land grab for initial public offerings, which is one of the highest margin businesses that any Wall Street firm can engage in.
Analysts realized [they could] get paid a whole ton of money on top of being a research analyst for bringing companies to market.
RR: So when the bubble burst, the analysts were exposed?
Price: Well, the question is, When the bubble finally burst, why was everybody so late to the party getting out?
The story around that is about being tied commercially to an investment banking capability. This economy slowed down in an unbelievable hurry. Not until the fourth quarter did the slowdown really start. It happened overnight.
While the general feeling now is, Gee, this analyst was out to lunch, I think analysts honestly believed that their valuations on a forward-looking basis were right. But they missed the economy slowing down so quickly.
And then pulling the trigger is difficult. If you are an investment banker for a fairly significant technology company, it is difficult to come out with a sell recommendation. I don't care what anybody says.
RR: They risk getting fired.
Price: Exactly. Prior to Regulation Fair Disclosure [Reg FD], it was difficult even if you weren't a banker if your analyst was out publicly with a sell recommendation on your stock, in some cases trashing the management team and speaking with candor about the prospects for the business or the business model.
If you did that, you couldn't get your foot in the company's door to discuss what's going on. The company would literally stop taking your calls. And as an analyst, if that happened, you couldn't report.
Reg FD has basically slammed the whole problem shut. The fact of the matter is there is no information you can access by getting inside the company that isn't going to be public. So now analysts have to get back to the analytical work that was being done 10 years ago.
If I'm an analyst, I have to call suppliers, talk to buyers and consumers, and look at other trends. Yes, I can read what the company puts out publicly, but that's what every analyst does. I have to dig a little deeper.
RR: So what exactly happened to the investment banking division at Prudential Securities?
If you are an investment banker for a fairly significant technology company, it is difficult to come out with a sell recommendation.
Jamie Price, Prudential Securities
Price: We looked at our strategy in the investment banking area and who the major players were. In the domestic IPO marketplace where we played, the top five players control about 80% of the new issue market.
To penetrate the top five, there were lots of tacks we could have taken. But then we considered what we wanted to stand for in the marketplace in our institutional and retail client businesses.
We want to stand for advice. And we saw this whole confluence around research conflicting with investment banking, and lots of press with quotes from anonymous people at asset management companies saying, I don't trust brokerage house research.
However, we noticed we were asked to be a co-manager, not a lead manager, on a lot of the new issues we did, based on our research capabilities. We got selected because we had an analyst who was well-regarded in the industry.
And we thought, Why don't we just go with a co-manager of choice strategy, and base that off a strong research franchise?
Now that research franchise is really driving our banking efforts, rather than banking efforts driving research. We think we can be No. 1, 2 or 3 in research and create a co-manager of choice strategy from a banking standpoint.
RR: So you definitely see conflicts between investment banking and research?
Price: I do, because we saw them internally, on a smaller scale. That's why I think there will be a lot of rethinking about how we present and utilize research.
Research, in and of itself, is an expense. But it can drive institutional sales and other things. The biggest commercial success of research from a margin standpoint is in the investment bank. So as long as that's there, it's a very difficult juggling act to do both well.
Firms like Merrill Lynch and others will have research departments that do well in Institutional Investor magazine rankings because of their sheer size and their institutional sales capability. But we asked ourselves, Are Institutional Investor rankings as relevant as [investor] performance? We pay more attention to the Wall Street Journal surveys of stock picking, performance and asset allocation. That's what's in an investor's portfolio.
RR: Do you think you'll be able to get or keep good analysts given the firm's shift away from banking?
Price: Less than 10% of our analysts' pay came from banking, so it's already not as big a deal to us. Plus, there is a core group of analysts who want to do pure research and Reg FD makes that easier. We believe having a differentiated business model will help us attract and retain talent.
RR: What does all this mean for brokers at Prudential Securities?
Price: First, the biggest single shift is that our research will be much more investor-focused, with the commercial success of research being measured by the performance in customer portfolios, both institutional and retail.
Second, if research is going to be investor-focused versus issuer-focused, asset allocation and macro research will play a more important role than individual stock selection. Stock selection is extremely important, but it has to fit within asset allocation instead of being tied to a banking deal.
How does that benefit financial advisers? They'll have much more clarity around the ideas, and the ideas are much more performance-driven.
We will judge our success by answering these questions: Does our research perform in a customer's portfolio and over time? And does the research department at Prudential Securities become known for its advice capability?
RR: Do investors really pay attention to analyst reports?
Price: No, they don't pay attention to the reports, but they certainly pay attention to the performance of their portfolios.
If the adviser is able to use his own firm's capabilities to supply advice and it works, he feels better about working there and the client's portfolio performs. That creates more value in the client's mind than if he did not have that capability.
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