Ignored by Wall St., Firms Turn to Research-for-Hire Outfits
When Carlsbad-based K2 Inc. bought Rawlings Sporting Goods Co. in March, along with the famous line of baseball equipment came something that K2 would rather not talk about: a company-paid analyst to write about Rawlings’ stock.
Despite an internationally known brand name and 116 years in business, Rawlings had become what some call a Wall Street orphan, ignored by analysts at the big securities firms. So last year it signed a one-year $25,000 contract with private research firm J.M. Dutton & Associates, whose analyst initiated coverage in November with a “buy” rating.
The dismal stock market, brokerage layoffs and regulatory reforms have helped shrink the number of publicly traded companies receiving Wall Street research coverage by more than 25% since 1999. For companies dropped by Wall Street or never covered in the first place, research-for-hire is one way of reaching potential investors.
But the practice carries a stigma, as K2’s reticence implies. K2 referred questions about Rawlings and Dutton to investor relations firm PondelWilkinson MS&L; in Los Angeles, where Vice President Angie H. Yang emphasized in an interview that K2 didn’t seek the relationship; it inherited it from Rawlings.
“Paid-for research is not something that K2 is interested in pursuing,” Yang said. “It’s certainly not something we believe the company needs to do.”
John M. Dutton, who founded and heads the Eldorado Hills, Calif., stock-research firm that bears his name, is accustomed to such slights. Yet Dutton maintains that getting paid directly by the companies he covers poses a less troublesome conflict than those faced by Wall Street analysts.
Wall Street’s research conflicts were vividly exposed during the year-long state and federal investigation that culminated April 28 in a $1.4-billion settlement between regulators and 10 of the world’s largest securities firms.
The investigation uncovered scores of e-mail messages in which analysts privately disparaged stocks they were publicly touting. The analysts acknowledged being under severe pressure to generate upbeat reports that would help their firms win fee-rich investment-banking business.
Dutton said his analysts, mostly former Wall Street veterans, enjoy working for his firm precisely because it doesn’t have an investment-banking or brokerage unit that might lean on the research department for thumbs-up stock recommendations.
“The only pressure they’re under is the pressure to be right,” said Dutton, a longtime Wall Street analyst and executive.
Dutton doesn’t guarantee positive ratings; a company that doesn’t like its coverage is free not to renew when its contract is up, Dutton said. The upfront $25,000 fee for a year’s worth of research -- four quarterly reports plus updates when news breaks -- is high enough by itself to discourage some financially shaky firms from signing up, he added. The reports are distributed largely over the Internet.
As of Friday, Dutton listed 19 of the 41 firms it covers as either “strong buy” or “buy” and 15 as either “strong speculative buy” or “speculative buy,” reflecting higher risk. Five other firms were rated as “neutral” and two as “not rated.” All four of the ratings that had changed with the most recent report were downgrades.
One Dutton customer who didn’t mind talking is William C. Bopp, chief financial officer of Alaris Medical Systems Inc., a San Diego-based medical-equipment manufacturer that Dutton rates as a “strong buy.”
Although Alaris, with 2002 sales of $460 million, is hardly a tiny company, three-quarters of its stock is held by a single investor, leaving only 11 million shares trading publicly, Bopp said in a recent interview. With the stock trading at around $5 or less for much of last year, the resulting $50-million public “float” wasn’t enough to get Wall Street’s attention.
“How are investors going to understand me if I don’t have coverage?” Bopp said.
Bopp overcame initial misgivings and decided to hire Dutton’s firm. He said the analyst assigned to Alaris was professional and thorough.
The coverage, which began in January, “got us some investor attention, but at the end of the day, it’s really going to be company performance that gets us noticed,” Bopp said.
As the paid-research industry tries to fill the gap left by Wall Street’s withdrawal of analyst coverage, some experts are voicing reservations.
“This cottage industry is looked upon with great suspicion,” said former federal prosecutor Christopher J. Bebel, a partner in Houston securities law firm Shepherd, Smith & Bebel. Investors, he said, should have their eyes wide open when considering any recommendation paid for by the company issuing the stock.
“There have been so many instances in the past where people without even the capability of conducting the underlying analysis issue glowing reports devoid of any rational basis,” Bebel said. He added that unscrupulous promoters calling themselves analysts sometimes work hand-in-hand with stock manipulators in “pump and dump” schemes.
The best check on abuses would be regulation, he said, noting that research-only firms such as Dutton aren’t subject to NASD inspection, as full-service brokerage firms are.
The National Investor Relations Institute and the Assn. for Investment Management and Research, trade groups for investor-relations pros and stock analysts, respectively, formed a joint task force last month to develop guidelines to improve analyst independence and objectivity. One of the subject areas is paid-for research.
Under NIRI guidelines, paid research is acceptable if done by qualified analysts; payment is strictly in cash and not shares of stock; fees and contract terms are fully disclosed; and reports don’t offer ratings or stock-price targets.
Taglich Bros. Inc., a small New York-based broker-dealer that also provides paid research, ignores the NIRI guideline about ratings and price targets, as does Dutton.
Not issuing those “would make our reports less useful,” said Francisco Clough, vice president for business development at Taglich Bros.
Taglich charges a $5,000 retainer, plus $1,750 a month for coverage. Unlike Dutton, it has an investment banking unit, which may do business with companies covered by its analysts.
Taglich faces the same potential conflicts that the Wall Street giants have struggled with, but Clough said the fee-for-coverage arrangement allows his research department to be completely self-financing and thus independent of investment banking and brokerage.
Besides, Clough said, there’s no such thing as conflict-free research. Even research boutiques that work exclusively for institutional investors come under pressure if they downgrade a stock in which a customer has a large investment, he said.
