In search of the last honest analyst

The quip is telling—and not just because there is plenty of truth to it. No, what’s really telling about this joke is the person telling it: a former brokerage analyst who now leads one of Wall Street’s most venerated research firms.

During the boom the analyst’s job was to cozy up to the company brass, not to question them. Or so the evidence would suggest. Recent disclosures of Merrill Lynch e-mails, in which allegedly independent researchers hyped stocks to the public while privately trashing them, are only the latest exhibits. The pumped-up stocks—no surprise—were those of companies with which Merrill had a lucrative investment-banking relationship. In a settlement with New York State’s attorney general, the securities firm has agreed to pay a $100 million civil penalty, reform its analyst-compensation system, and apologize for failing to address the obvious conflicts of interest. But as Fortune and others have pointed out, the numbers have long illustrated the failure of Wall Street research. Last June, during the height of the recession—when even the most optimistic CEOs were unable to hide the bad news—investment analysts couldn’t find a stock they couldn’t tout. Of 26,451 buy, hold, and sell recommendations, only 213 were sells.

In fact, stock research sank so low during the bubble that it actually became a contrary indicator of a stock’s performance. Researchers at the University of California and Stanford reviewed almost 40,000 stock recommendations from 213 brokerages during the year 2000. The most highly rated stocks had a -31% return for the year, according to the study. Meanwhile, the stocks least favorably recommended (that is, the sells) soared an annualized 49%—a differential of 80 percentage points.

Given that, er, performance, one can’t help wonder if there are any analysts on Wall Street worth listening to these days.

Which brings us back to Sallie Krawcheck. For years her firm, Sanford Bernstein, has been doing independent stock research for thousands of institutional clients the way it’s supposed to be done. The firm does no investment banking whatsoever. But more important still, its sophisticated takes on companies are far more often right than wrong. In other words, this Wall Street firm makes its clients money.

Fortune

Other brokerage houses that do little if any banking, such as A.G. Edwards in St. Louis and the newly revamped Prudential Financial, have also been proving their relevance in the recent market turmoil. Both are turning out researchers who consistently make the tough calls.

With these admittedly modest signs of encouragement, we embarked on our annual quest: to see if we could find a few good men and women on Wall Street—analysts who are not only honest but gutsy enough to share that candor with the rest of the world. We looked for researchers who have been not just dead-on with their calls but also accurate across a span of companies in a given sector—and in both bear and bull markets.

To find these elite stock pickers, we returned to Zacks Investment Research in Chicago, which compiles a database of nearly 28,000 stock ratings from some 2,900 investment analysts. For the third year in a row, Zacks provided us with annualized returns for analysts based on the sum total of their upgrades and downgrades, and also crunched the data from the historical records. We began with a handful of consistent earners in each sector, and then sifted through them. The most important quality we looked for was candor. Specifically, we sought out those not afraid to bash the companies they cover. Next, we asked ourselves a key question: As private investors, would we want to pay for this person’s wisdom? And make no mistake, that’s exactly what you’re doing when you use a full-service brokerage—you’re paying a premium to trade stocks that you could trade online for pennies.

Finally, we tapped each of our pros for his or her strategies—and favorite stock—for the coming year. In case you were wondering, the portfolio of picks from last year’s All-Stars was up an impressive 13% as of press time, compared with a drop of 13% for the S&P 500. Here, our 2002 Fortune All-Stars.

Technology/Semiconductors

The only thing rarer than an unconflicted analyst is a chip researcher with a value philosophy. Meet 40-year-old Vadim Zlotnikov, who covers semiconductor and PC stocks for Sanford C. Bernstein—he’s both. For a decade, this self-deprecating Ukraine-born electrical engineer has been a contrarian in a momentum universe.

A former captain of his high school math and chess teams and the holder of a master’s degree from MIT and an MBA from Stanford, Zlotnikov thrives on science—and the chance to disprove popular theories about valuations.

At the height of the tech bubble, for example, with the Nasdaq rolling toward 5,000, he warned that tech valuations were so stretched that a major shakeout was inevitable. That was blasphemy to analysts in the sector. But his argument was backed by months of channel checks with companies up and down the supply chain, followed by a grueling quantitative analysis. The conclusion: Wireless handsets would have to become as sought-after as, say, food in order to justify the share prices. “I just didn’t see that happening,” he says.

Among those sky-high stocks was Qualcomm, then at $180. Zlotnikov calculated that to justify Qualcomm’s multiple of 400 or so, two-thirds of the earth’s population would have to own a CDMA handset in a decade. As more high-profile analysts were screaming buy, Zlotnikov quietly told his clients to get out. The stock peaked that month and began a 75% descent.

Last September the researcher, who was recently promoted to chief strategist, scored big with bullish calls on semiconductor equipment makers like Applied Materials, Lam Research, and KLA-Tencor when valuations were below average despite improved fundamentals. Shares soon rallied. He then downgraded the sector just before another 15% pullback.

This remains a market in which investors need to avoid losers by focusing on valuation and sales growth, he says. One name he likes now is ST Microelectronics (STM). The stock was hammered after the company, which managed to remain profitable during the downturn, overbuilt to handle demand that never materialized. As demand improves, however, that capacity will be a huge advantage.

Automobiles

Prudential’s auto researcher, it seems, likes to drive on both sides of the road. Not only is Mike Bruynesteyn good at making money for investors (he’s the only auto analyst out of 44 tracked by Zacks with positive returns in each of the past two years) but he has a knack for saving them money too. Take for example the call he made in March 2001. Bruynesteyn, a Fortune All-Star last year as well, recommended dumping DaimlerChrysler with the stock at $52. Fellow analysts scoffed. By autumn, shares had fallen to $28.

And then there was his coup last September, when auto stocks were being bashed. Much of the selling was prompted by a leading industry report that indicated a much bleaker than expected picture. That report led most of the Street to project 2002 light-vehicle sales at 14 million. But Bruynesteyn doubted the market was that weak. Scrutinizing the numbers, he discovered that they hadn’t been adjusted for seasonality. The corrected figure suggested an estimate of 16 million car sales instead. Bruynesteyn issued a report urging investors to snap up auto suppliers. The stocks rallied 33% through the end of December.

Bruynesteyn, 38, sees difficult times ahead. The Big Three are losing market share, purchasing incentives remain too high, and, worst of all, interest rates are likely to move higher. (Historically, rising rates have been tough on autos.) For those reasons, he’s neutral on GM and DaimlerChrysler, while telling investors to sell Ford because of its dwindling share of the market and lack of new vehicle designs.

Bruynesteyn speaks more favorably of some suppliers who stand to gain from outsourcing by the Big Three and their own market share growth. The strongest right now, he says, appears to be Lear (LEA). The maker of interior parts like instrument panels and seat systems has a strong management team, a below-average P/E ratio, and plenty of free cash flow. Bruynesteyn predicts that Lear will perform well until the Fed begins to raise rates—which he thinks makes it a short-term pick.

Defense/Aerospace

Flash back to March 2001. It’s past midnight, and Steven Binder is dialing for dollars in the family room of his home. He’s trying to find airline execs in Asia who can tell him about demand for U.S. passenger jets. Binder, a defense and aerospace analyst at Bear Stearns, finally gets through to an executive at a large carrier. He fires off a barrage of questions about business conditions and the outlook for Boeing. The executive lets it slip that Boeing has visited his company to outline top-secret details of its plan for a completely new jet called the sonic cruiser.

That is a dramatic discovery, and Binder doesn’t delay getting the news to his investors. After stunning Boeing with a call to confirm its project, he tells shareholders about the jet, warning that it could require a huge amount of R&D, thereby cutting into profits. Says Binder: “I can almost smell when I’m on to something big.”

Such scoops have pushed Binder to gains that trounced the average defense and aerospace analyst, as tracked by Zacks. But the numbers are only part of the story about this 43-year-old, who might just be the toughest, most ornery analyst on the Street. He is secretive, blunt, intimidating, and curmudgeonly. Ask Binder to name the executive who spilled the beans about Boeing, and he snaps, “I can’t tell you that. If I do, everyone will know who my mole is!” Binder, in fact, despises press interviews almost as much as he dislikes talking to investment bankers or going out on the road to sell his research to institutional investors.

In a market in which too many analysts skip over the tough questions, he is the quintessential stock detective. He generally avoids talking to the companies he rates, hates mixing with other analysts, and prefers to do most of his work over the telephone. His most valuable tool is a 15-page list he has compiled of more than 250 industry sources from Islamabad to Johannesburg who provide him with insight on market conditions. He guards his list zealously. “I don’t rely on investor relations or the CFO or the CEO,” he barks. “Everyone thinks to be plugged in you have to talk to the CEO. That’s b.s. The most plugged-in people are at the second or third level.”

Dogged use of that contact list has kept Binder apprised of the fast-changing environment for defense and aerospace companies. Since Sept. 11, both sectors have been at the center of the market’s attention, and each fresh threat of terrorism or comment by the White House about an expanded conflict in the Middle East has sent stocks in all directions. Expected increases in defense spending—Binder estimates a 7% to 8% compound annual increase in demand for weapon systems—have boosted defense stocks, while aerospace companies have struggled from the slump in air travel. He estimates that 2,000 planes are sitting idle in hangars and adds that carriers are in no hurry to buy new jets.

With that in mind, Binder is neutral on 11 of the 15 companies he covers. He’s scouting for companies that are keyed in to defense spending but also focused on increasing their return on capital. That points him to Lockheed Martin (LMT). Of its peer group, Lockheed, says Binder, has the most attractive growth rate with respect to its valuation. It also has conservative accounting. An added plus is an advanced upgrade of the popular F-16 fighter that could bring in another $1 billion in revenues per year.

Consumer products

Alice Beebe Longley took an odd route to Wall Street—by way of her tenth-grade English class. (Longley was teaching it.) Back in 1981, after editing research reports in her spare time, Longley, who has a Ph.D. in comparative literature, turned in her red pen and began covering companies. The Credit Suisse First Boston analyst has dabbled in a variety of sectors, but in recent years settled into the often overlooked category known as mid-cap consumer products. These lesser-known companies, such as Church & Dwight, which makes Arm & Hammer, and beauty-products maker Alberto-Culver, have been whipping the big boys. And so has Longley. She has a winning record three years running, up 8% in 2001, 10% in 2000, and 6% in 1999. So what’s next for the sector?

Longley says the prognosis is decidedly mixed. Many companies have consistent fundamentals and should benefit from a strengthening economy. But the group could also be hurt if investors move away from defensive stocks. That said, her extensive industry data point to two types of companies that might prevail: those with a defendable brand-name, and the value consolidators—low-cost companies that are gaining market share through organic growth and acquisitions. An example of the former is International Flavors & Fragrances (IFF), a company that has used CSFB to execute deals. (Longley’s record reveals a schoolmarmish independence when it comes to her firm’s banking clients.) IFF makes scents for companies like Calvin Klein and P&G. A few years back it ran into trouble caused by some inept management, she says. Profit margins eroded and the stock sank 66% over a one-year period. The reason Longley likes the stock now is that the new management team has boosted profit margins from 16% to more than 18% and sales are more stable.

Computer hardware

On a recent afternoon Toni Sacconaghi was reviewing the outlook for computer hardware stocks when he suddenly stopped in midsentence and smacked his hand against his desk. “I’m pounding the table,” he said with a smile.

The reason was flashing on his desktop: Hewlett-Packard was up on the day. Hours earlier Sacconaghi had issued a report raising HP to a buy. Until then, the Sanford Bernstein researcher had been one of the biggest bears on the stock, having first issued a neutral market weighting back in June 2000, with the stock at a split-adjusted $63. His argument at the time was that its dependence on the PC market exposed HP to any slowdown in business. The call was dead-on. Now, with the stock trading under $17, he was telling investors it was a bargain.

At 36, Sacconaghi is the most accurate voice in computer hardware. Since joining Bernstein in 1998 after six years as a McKinsey consultant, he has combined thorough research with gut instincts about what moves a stock. In 2001, when the average hardware analyst lost 16%, Sacconaghi gained 34%.

Those numbers were the result of a handful of spectacular recommendations. After Bernstein’s research indicated there would be a massive slowdown in tech spending—and Sacconaghi’s own checks with industry suppliers and end-users confirmed the findings—he insisted that HP and Sun Microsystems were likely to suffer. Going further out on a limb, he told his clients to reallocate that cash to two out-of-favor stocks, IBM and Lexmark. The theory was that recurring revenues and lower exposure to risk would allow them to sustain profits during an economic downturn. He was right on all counts: IBM and Lexmark soared; HP and Sun tanked.

Like his fellow All-Stars, Sacconaghi recommends judicious cherry-picking rather than a broad sector bet. Technology spending, he predicts, will be unimpressive because of a lack of new software applications and the fact that companies simply have enough hardware in place. In March, citing accounting questions and concerns about the growth of IBM’s services operations, he cut his rating on the stock to neutral. Not long after, IBM pre-announced weak results, as the stock fell from above $100 to $76. Sacconaghi does see a chance for gains with Hewlett-Packard (HPQ). Now merged with Compaq after an ugly proxy fight, he says HP’s parts are worth more than the whole company.

Banking/Financial services

Why has David Stumpf succeeded while so many other bank analysts have struggled? Perhaps it has something to do with having been a bank examiner for the Richmond branch of the Federal Reserve before he turned to examining stocks for A.G. Edwards.

Briefcase in hand, he’d show up at regional banks across the Southeast and spend upwards of a week reviewing their books. The lessons he learned then can be seen in his research, which concentrates on issues like soundness, compliance, quality, and risk management—issues, that is, that ultimately drive stocks.

Stumpf’s due diligence has a lot to do with his record. Though he has been criticized for not being bullish enough at times, Stumpf, 38, steadfastly refuses to shout “buy!” just because it will make people happy. He’s a stickler for details, particularly when it comes to credit quality.

Such an approach allowed him to recognize before most other analysts that the “Enron and Argentina” problems that had hit the money-center banks like J.P. Morgan Chase and Citigroup were unlikely to do major damage to regional banks. It also helped Stumpf recognize just how healthy that regional crop has become—it had recovered from its travails in the late 1990s, after an M&A wave left many regionals floundering with poor management and angry customers.

Today, says Stumpf, regional banks are more decentralized and quicker to respond to potential problems. That does not make him a diehard bull by any stretch. He says the regionals, which won’t get as much bounce from the economic rebound as the big national banks, are likely to see their stock prices lag. One he does like, however, is North Carolina-based BB&T (BBT), whose stock trades at a discount to the sector. He expects the bank, which is among the most reliable he knows, to rack up 12% annual earnings growth.

Real estate

Jim Sullivan has the kind of calming voice you’d want to hear if you were standing on a ledge wondering if you should jump. That’s what real estate investors could use just about now. With so many investors asking if there is a real estate bubble, we looked up the Prudential researcher in search of guidance. At 51, he’s the dean of analysts who cover real estate investment trusts—which by law pay out 90% of their profits to investors. Sullivan’s calm, reasoned approach is certainly supported by his performance; his picks were up 28% in 2001 and 12% in 2000.

The analyst has been around real estate projects since he was a boy. Growing up in Boston, he and his father, an immigrant from Ireland, would spend Sundays driving around in search of houses that the elder Sullivan could buy and fix up for a profit. Later, after spending the first part of his career as a tax lawyer and then as the founder of a container leasing company in Hong Kong, he ventured into his own real estate projects.

Sullivan believes that the office and residential markets—which make up roughly half of the REIT business—are in trouble right now. In cities like San Francisco and Boston, developers and landlords had counted on huge demand from tech, telecom, and financial services companies to keep rents at a permanent plateau. Given the shakeout in all three sectors, demand for office space has plunged, and prices for premium locations are down by as much as 50%. That has trickled over to the housing market, where developers had been buoyed by easier lending conditions and began new projects just as demand fell off. Investors who listened to Sullivan knew well in advance that trouble was brewing in the office and apartment sectors. These days Sullivan continues to say that the apartment sector will underperform. He’s neutral on offices.

Instead of those traditional plays, Sullivan is endorsing what he terms the “blue collar” properties, industrial sites that have skirted the mainly white-collar recession, as well as hotels and regional malls, which have remained on solid footing. He’s particularly bullish on MeriStar Hospitality (MHX), which operates full-service hotels like Hilton and Sheraton. Sullivan points to an expected 35% increase in fund flows from operations and an economic rebound that will lead to increased travel. Shares, he says, are also trading below the value of the companies’ assets.

Biotech

Biotech is one of those sectors that always seem to be brimming with opportunities—to lose money, that is. Back in 2000, people speculated that every genetic ailment would soon be cured. Shares of tiny firms skyrocketed—then plunged when the results were slow to materialize. Now that some companies are making dramatic progress, biotech is tagged with the stigma that it’s too much fiction and too little science.

What’s an opportunistic, iron-stomached investor to do? Meet the research tag team of Craig West and Alex Hittle, the bio-twins, as they’re known at A.G. Edwards’ home office in St. Louis. Since teaming together two years ago, the two have compiled a record that is unmatched by the 99 other biotech analysts.

Think of West as the right brain, with a background in molecular biology and an MBA. Hittle is the left brain, a history major with a master’s in international relations and economics. The two joined A.G. Edwards as associate analysts in 1996 and became fast friends. When the firm decided to expand its biotech coverage, they argued that a team approach would allow for more in-depth research. The concept seems to have worked, in part because the two are so willing to share ideas, not to mention finish one another’s sentences. Consider this conversation:

Hittle: “There’s an investment opportunity out there right now…”

West: “…and that’s because of…”

Hittle: “…value and visibility.”

Yes, talking to Hittle, 39, and West, 35, can give a person a neckache, but they’ve got some compelling arguments. They believe that biotech investing has gone through three stages—exuberance, despair, and now opportunity to buy workable concepts at low prices. After two years of falling shares, many stocks are trading below the value of their cash on hand. Any drug that is successfully brought to market would be a boon to the stock’s valuation. True, it’s not like valuing General Motors, but then this is biotech, a sector in which investors are being asked to buy into something that might not be proven for a decade. The requirement, therefore, is to be careful.

Though they believe owning a basket of biotechs in a diversified portfolio is the safest approach, the team’s top pick is Human Genome Sciences (HGSI), which both analysts own in their personal accounts. They insist that has not shaded their view. Because Human Genome, which has fallen from $77 to $16, has five gene-based drugs to treat cancer and infectious disease in the pipeline, and lots of cash, it’s a stock to hold on to. No, the company hasn’t made a dime. Nor do West and Hittle expect even a significant amount of revenue until 2007. Remember, West cautions, “biotech isn’t about the next year, but figuring out where investors want their portfolio positioned for the next ten years.”

Reporter associates: Doris Burke, Ellen Florian