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U.S. Securities and Exchange Commission

Speech by SEC Chairman:
2005 CFA Institute Annual Conference


William H. Donaldson

U.S. Securities and Exchange Commission

Philadelphia, Pennsylvania
May 8, 2005

Thanks, Jeff, for that generous introduction, and for inviting me to join you tonight. I am honored to be hosted by the CFA Institute and to have this opportunity to discuss some of the issues facing the analyst profession.

I know the evolution of this institute has a long history. Contrary to what some might think, I was not present at its creation way back in 1925. But soon after my partners and I at Donaldson, Lufkin & Jenrette opened our firm, in 1959, we decided to pursue the coursework associated with becoming a CFA, because we recognized the value in seeking to turn the occupation of security analysis from a trade into a profession. And since then I have seen you grow into a highly-respected and multi-faceted organization, serving thousands of investment professionals throughout the United States and the world. I applaud your dedication to education and excellence, and to advancing thought leadership on the critical issues facing the investment community. Your motto -- “setting the global standard for investment professionals” – truly defines a laudable goal.

As you all know, the past few years have been extremely busy for the SEC. I could certainly give a speech this evening that touches on all the different issues we’ve tackled, ranging from the Sarbanes-Oxley mandates and corporate governance, to mutual funds, hedge fund advisers, and equity market structure, to name just a few. In a few minutes, I’d be happy to take your questions, or respond to your thoughts on any of these issues, but before I do I’d like to focus on a number of issues related to investment research and the analyst profession. Before going any further, let me issue the standard mandatory disclaimer that my remarks here are my own and do not necessarily represent the views of the Commission or its staff.

I take special pleasure in joining you here tonight, because I spent many years immersed in the world of investment research and analysis. At DLJ we placed a premium on producing in-depth, comprehensive research analyzing public companies. In particular, back in the early 1960s we saw that the emerging growth of mutual funds and increasing equity orientation of pension and other institutional funds was creating a new breed of professional investors. These investors were faced with escalating demands for performance and were inadequately served by so-called “research,” which was then really only statistical reporting, designed for individual investors. Institutions at the time were crowded into a relatively small universe of household names, such as “the generals” – General Electric, General Foods, General Motors, and the like – which soon became the “nifty fifty” with PE valuations that far exceeded realistic prospects for growth. That left many other companies, who were leaders in their fields – such as Dun & Bradstreet, Diebold, A.C. Nielsen – or fledgling companies in new industries – such as Xerox – as wallflowers. The institutions did not have the courage to move away from the big names because they did not have the research base to truly understand the fundamental position or future of these smaller companies. My colleagues and I set out to analyze them in a comprehensive manner, akin to the work usually associated with the management consulting profession. We recognized that buy-side clients would reward us with commission business in exchange for sound, long-term in-depth investment analysis. The market seemed to recognize the value of the product we were offering, and happily we were able to make a living off of it.

Today, research and analysis remains as important as ever, though much has changed in the business over the past 45 years. As you know, when brokerage commissions were deregulated in 1975 a new set of pressures beset the business model of the sell-side analyst. As competition squeezed brokerage commissions ever tighter, and with the development of the efficient capital markets theories and a resulting emphasis on passive index funds, many sell-side firms began demanding that their analysts prove their worth in new ways. Over time, analysts responded to these pressures in ways that I believe had a fundamentally negative impact on their ability to think and write for the long term. Some analysts believed that in order to survive they needed to cast their lot with the investment bankers. Research became more like the statistical reporting that prevailed in the 1950s and ‘60s and earlier, and there was little or no analysis of what made a company tick. As standards slipped, it became easier to understand the old Wall Street maxim that “you start as an analyst but you end as an ambassador.” The Wall Street Journal noted recently that at the height of the boom in 2000 – and just before the markets started to tumble – 95 percent of the stocks in the S&P 500 had no sell ratings at all, and not a single S&P 500 stock had more than one sell rating.

Part and parcel of this unrelenting optimism was a culture that perhaps even encouraged analysts to cut a number of professional corners. To cite just two of many examples, untested – and unreliable – valuation methods became de rigueur, and income statements took precedence over balance sheets. One research analyst captured the boom-years zeitgeist when he told a magazine reporter that there was nothing wrong with his helping to sell investment-banking services to corporate America: “What used to be a conflict,” he said, “is now a synergy.”

As the structures supporting the analyst profession changed, so did the information upon which it rested. Data which was once available to a privileged few, and was difficult to obtain, became available to anyone with an Internet connection. But this transparency, and “information proliferation,” did not necessarily translate into better analysis. Indeed, there’s probably more unreliable information – masquerading as “analysis” – floating around today than ever before.

This is where all of you come in. As chartered investment research professionals, you are charged with producing unbiased research about the companies, or industries, you cover. And if you toil on the so-called buy side, you are increasingly called upon to develop in-house quality research that is needed to replace or augment the short-term focus of buy-side suppliers. In either role, you are functioning as the backbone of the investment industry, and the quality of your work is critical to determining the long-term cost of capital, and to measuring the vitality of our markets and our economy.

As you think about the roles you can play in the investment business, I recognize that for many of you this continues to be a time of uncertainty. In the aftermath of the dot-com bubble, and the Global Settlement, investment research remains in transition. A number of fundamental questions have yet to be answered: How can we ensure the continued development of a robust marketplace and compensation for comprehensive, high-quality research? What can be done to promote coverage of small- and mid-cap companies in promising sectors that are sometimes ignored? And, of particular interest to me, how can analysts reorient themselves to focus less on the earnings-per-share game and more on the long-term health of the companies they cover?

I’ll return to this topic in a few moments. First, let me review where things stand with the Global Settlement, and also offer some thoughts about how its principles may apply to fixed-income research.

Implementation of Analyst Settlement

Turning to the Global Settlement, I don’t think it’s necessary to recite all that went wrong in the research-analyst community. And as bad as things were in recent years, I do believe investment research and analysis has begun to change for the better. The Global Settlement has helped to bring new and better practices to the analyst profession, as it requires the settling firms to undertake reforms that will insulate research analysts from investment banking pressure.

The Commission staff, as well as the other regulators who participated in the settlement, continue to make efforts to ensure that the settlement agreement is implemented efficiently and in an even-handed manner. The independent research portion of the settlement calls for independent consultants to procure independent research for the settling firms over a five-year period. These consultants are now in place and have completed the process of picking those independent research firms that will serve the settling firms’ customers. As of last July, independent research was made available to the clients of the settling firms, while the consultants have worked to ensure that the research is conflict-free, high-quality, and useful for investors.

A different part of the settlement calls for the appointment of independent monitors to submit a report on the effectiveness of the settling firms’ procedures for compliance with the terms of the settlement. These monitors, who will begin their review this month, will look at the separation of research and investment banking, analyst compensation, transparency of firm research and availability of independent research.


Fixed-income research wasn’t directly implicated in the scandals of the late 1990s, and is not covered by the terms of the Global Settlement. But there are still questions facing fixed-income research that are substantially the same as those that laid the groundwork for the Global Settlement. For example, is it the case that fixed-income analysts are any less susceptible to pressure from their colleagues in investment banking, from the debt syndicate desk, or from corporate clients themselves? Industry participants, including issuers and customers, should continue to be proactive in self-examining and addressing conflicts as they arise: How are you managing the pressure created when an issuer threatens to retaliate against the analyst or the firm? What about the pressure created when an institutional investor threatens to withdraw business from the firm if the analyst downgrades a portfolio security?

To the extent that bond analysts have been able to resist the pressure to hype favored banking clients, has it been because of the counterweight provided by the institutional nature of the buy-side customer base? If so, what will happen as the character of that customer base begins to shade more into baby-boomer retiree retail?

I hope those of you in fixed-income research will turn your attention to questions such as these, and ask whether there is something to be learned from the history that gave rise to the Global Settlement.

The Challenge to Move Beyond Short-Termism

I’d like to turn to a more fundamental problem that, in my view, affects multiple aspects of America’s corporations and securities markets. It is the tendency towards a short-term outlook shared by management, investors, and financial analysts. I realize that speaking out on the need for a longer-term approach to investment analysis is akin to speaking out in favor of baseball, hot dogs, and apple pie – it’s something (almost) everyone supports, in an abstract way.

The backdrop to this phenomenon is the pressure that many analysts have felt to justify their existence on a quarterly – if not daily – basis. Many have believed, with some justification, that it is no longer good enough to tell your clients where the best investments are – particularly if those investments require the fortitude of bearing with a company through a few lean quarters while a solid management team sharpens its strategy and plans for the long-term. Over time the key question has changed from “what is the best investment?” to “where are the best short-term profit opportunities?” These are two different questions that more often than not will yield different answers.

Over time, analysts have become obsessed with the question of whether a company meets its quarterly EPS numbers, and not with whether a company is built to last. And because of the considerable clout of the sell-side analyst, this shift from long-term-thinking to short-term results has echoed through to company managements and to professional investors. The focus on short-term results has, I believe, had a counter-productive influence on companies, on investors and on analysts themselves.

For companies, the short-term outlook has given rise to the disturbing syndrome of trying to force earnings into an artificial model of uninterrupted quarter-to-quarter growth. One study found that from 1999-2004, nearly half of the companies in the Dow Jones Industrial Average always met consensus earnings estimates, or beat them by a penny. “Making the numbers” often results in unsound corporate strategies, which pay no regard to the cost of postponed investment. Such a goal is often achieved only by bending accounting standards.

Highlighting the breadth of the problem is the finding contained in a National Bureau of Economic Research working paper. The authors surveyed 401 financial executives and 78% said they would sacrifice an initiative they expected would create economic value if it would affect their ability to realize smooth earnings.

I recognize that analysts are not wholly to blame for this short-term outlook. Indeed, a recent McKinsey paper points out that companies need to become more effective in identifying investors who will support a company’s long-term outlook, and must also invest the time with research analysts to make the case for the company’s future competitiveness.

The challenge for analysts, companies and investors is to turn this ship around. There are some encouraging signs, particularly at the company level. I believe that independent compensation committees are beginning to focus more on the long-term contributions that management makes and less on quarterly results. I think the coming requirement that companies expense their stock options will reinforce this trend. The Sarbanes-Oxley reforms, particularly the Section 404 internal controls requirement and the creation of the Public Company Accounting Oversight Board, should reduce the opportunities for quarterly profit manipulation designed to affect short-term results.

I hope that investors will begin to change, particularly when they see the value of an investment in a company that is managed for the long-term. But it will require the combined efforts of investment professionals and company management to lead the way.

I am also hopeful that analysts will choose to focus their talents on a company’s fundamental value and its long-term prospects. A short-term outlook may yield short-term profits for your clients, but this outlook will present an incomplete – and likely distorted – picture of the companies you’re covering. To state an obvious, but often-overlooked, fact – quarterly earnings do not reflect companies’ long-term viability. Identifying the factors that will drive long-term growth – such as personnel, strategy, financial strength and flexibility, internal corporate governance, innovation, and customer service – may be more difficult to quantify, but they offer a more accurate and complete portrait of a company’s future and, by the way, are critical criteria for determining executive compensation.

An interesting – and encouraging – illustration of what I’m talking about appeared in the New York Times on May 2nd. The article described how an Internet retailer is pursuing a number of initiatives aimed at developing new areas of its business. While the initiatives have been blamed for the company’s stock price falling, the CEO has stood his ground: “If we take care of customers,” he said, “the stock will take care of itself in the long term.”

I have also been pleased to see some securities firms take decisive steps away from short-termism in their investment research. But there is much more to be done. Rather than focusing on asking company management whether they are “comfortable” with the First Call consensus estimate, why not deepen your inquiry as to their strategic plans? What do they see the company doing four years down the road, and what sorts of investments – and sideways movements or interruptions of interim earnings – will be necessary to get there?

This approach will, ultimately, better serve investors, and it will also gradually temper the pressures on some corporate executives to fudge the numbers. It would behoove us all to remember the words of W. Edwards Deming: “People with targets, and jobs dependent on meeting them, will probably meet the targets – even if they have to destroy the enterprise to do it.”


Let me offer a final thought on the future of your profession. Investors of all sizes and orientations will always seek out value-adding opinions, and will thus continue to demand research that is timely, accessible, affordable, and, most important of all, accurate.

The best of you are expert at analyzing a company’s business model, critiquing its strategy and explaining what it needs to do to win in a competitive marketplace. I have a modest proposal. I’d ask you to focus your considerable expertise on a question closer to home. There is a huge demand for high-quality investment research. There are literally millions of investors in this country who want to understand how to build a durable, long-term portfolio. Who among you can figure out ways to deliver this product – a product that the market clearly wants – and ways for you to profit from it? It’s a real challenge, but I am confident that you are up to the task.

Thanks again to the CFA Institute for giving me an opportunity to speak on this important topic, and thank you all for listening. I’d be happy to take your questions.


Modified: 05/09/2005