Article

Analyze This

By Hannah Wallace December 31, 2006

To get to Ned Davis' Venice office in a nondescript strip mall on Bird Bay Drive and U.S. 41, you walk past the receptionist, turn right, go through a labyrinth of corridors, ramps, and seam-bursting offices that house many of the company's 62 employees, turn right again, climb two flights of stairs, and turn left and right again. By the time you're leaving the building, your internal compass is so messed up you're prone to make wrong turns into lunchrooms or closets.

This confusing maze is the headquarters of Ned Davis Research, a fixture in the financial industry, and reflects 26 years of steady, organic growth in the same humble building.

A major factor in NDR's success has been the company founder's fame. Davis may be working in a Southwest Florida retiree haven, but he is well respected among the financial crème in New York City. On Wall Street, the bearded Nashville native with the Southern drawl has steadily built a reputation as a cool-minded "quant wonk." Over the past quarter century, he became known as an expert number cruncher and chart plotter, looking for patterns and trends in market history in order to understand the present. His company's particular niche in the fragmented independent research market is to help institutional investors with huge portfolios decide when to buy or sell.

NDR has been thriving in this niche: Today, some 1,000-plus customers make revenues in the $20 million range. In a recent survey among such big institutional investors, NDR ranked fourth among all independent research firms in terms of number of clients. In the 2004 survey, NDR was in a tie with one direct competitor, Montreal-based BCA Research, and was nipping at the heels of another, ISI Group of New York. In other words, NDR is a top player in the quantitative research niche.

In the era of day trading, someone who looks back as far as 1881 may seem out of date. But NDR's detached long-term perspective leads to conclusions that are head-turners for investors.

Take this: What do you think is better for markets, high or low corporate earnings? Below-trend earnings growth typically boosts stock prices, NDR found in a report that correlated earnings and stock prices since 1958.

Or swallow this: Which is better for markets-Republican or Democratic presidents? Since 1901, NDR found, the Dow Jones average annual gain, after inflation, has been nearly twice as high when a Democrat occupied the White House. (To be sure, markets seem to love political gridlock: The biggest gains happened during Democratic president/Republican Congressional line ups).

Davis didn't get any formal schooling in his field. He entered the world of finance in the late 1960s with a degree in French from the University of North Carolina.

"My interests were all verbal, but my aptitude, quite frankly, is average," Davis says. "My math skills were high, but I wasn't interested in any math areas."

A summer job at J.C. Bradford & Co., a brokerage in Nashville that was later swallowed by UBS, gave him an opportunity to combine his talent and inclination-working with numbers and writing about his views. He got hooked for life and continued to work for Bradford for a dozen years.

Davis' data analysis skills are self-taught. "I like to encourage people to motivate themselves and do it," he says. "When you learn it yourself, you feel like you own it."

Research and analysis remain at the core of his activities today. Davis has always been more inclined to focus on the "product"-in other words, have fun with research-than to micromanage his growing company.

Personal inclinations are what made him move his business from Nashville to Venice in 1978. In the pre-Internet era, such a lifestyle decision was unusual. And southwest Florida isn't exactly an easy region for recruiting top-grade market experts.

At the same time, he is not so easygoing or wonkish to lose touch with the necessities of operating a business. From day one in 1980, when he started Ned Davis Research with two colleagues from J.C. Bradford, he and his partners decided to set up a full-blown, separate sales department.

Says Davis: "You'd like to believe that your research is so good it sells itself. But, in fact, this is very, very rare."

Partners Ed Mendel and Kent Regenstein founded Davis, Mendel & Regenstein Inc. to serve as the company's marketing arm and registered it as an NASD brokerage. The Atlanta firm is a full subsidiary of NDR and is conveniently located at one of the biggest airline hubs in the world.

"That's one of the reasons we've had a lot more success than some other independent research companies," says Davis. "I hate to say it, but marketing is 50 percent of the sale."

Davis' hands-off approach (he refers to it as the "Ronald Reagan" model) and his take-ownership mantra shaped the management style at Ned Davis Research.

The employees, Davis says, "work like owners. Everybody does their little thing around here. They're each their own entrepreneurs. I try to set up a division, a standard, but I'm really not telling people what to do. We don't force people to say anything. It's pretty loose. People dress the way they want to dress. They've really taken over the company in terms of running it, which is fine with me."

"He is not involved in management," confirms Robert Schuster, NDR's chief operating officer.

A "leadership council" that includes execs from both Venice and Atlanta meets once a month to take the big decisions.

In order to stimulate entrepreneurial spirit at the company, Davis and co-owner Mendel decided to sacrifice a good chunk of their shares and create an employee stock ownership plan. Every employee begins to receive company shares after the fourth year; 20 percent of the company is now owned by the people who work there. The ESOP may or may not have played a role in this, but the steadiness of the NDR management team is remarkable: All core people have been with the company for 15 to 20 years.

The decision in 1999 to give employees a stake came shortly after Davis pulled the plug on a takeover by competitor BCA Research.

"We announced the merger in the paper," Davis says. "But after we had a handshake deal, they started negotiating again."

True to the entrepreneurial cliché, Davis says today is the most challenging time his company has ever faced.

That's not to say that NDR's bottom line is suffering. The number of clients never dipped; in fact, it's at an all-time high. But NDR and the independent research industry in general have been facing major challenges over the past few years.

"Institutions are rethinking how they pay for research," Davis says. "Budgets are tight, business is competitive."

The problems surfaced as a nasty surprise amid the euphoric business climate of 2002. Back then, the independent research industry seemed to be on the verge of a growth explosion. Only five percent of the investment research market was covered by independent firms such as NDR, a trade association estimated that year. Even large institutional investors were only committing 15 percent of their research money to the independents. The lion's share traditionally was being held by company-side investment banking firms whose primary business was to raise capital for companies.

But then, the Enron, Adelphia, WorldCom and Global Crossings scandals broke. Too-rosy research reports-performed by the same investment banks that had a stake in companies' stock prices-got a fair share of the blame for the disasters, and regulators moved to separate investment banking from investment research.

Part of the separation process became the 2002 "Wall Street Settlement" between regulators and stock exchange operators. The agreement caused quite a bit of euphoria in the independent research scene. That's because large Wall Street investment banks such as Goldman Sachs or Bear Stearns committed to spend $500 million on independent research over five years.

So independent research, one should think, should be on the rise. But it's not, said a Washington-based trade group two years after the settlement. In 2004, the Investorside Research Association surveyed 37 research firms, and found that 65 percent had reduced staff or postponed hiring.

The main reason behind the new troubles was the same newfound sensitivity about conflicts of interest that had propelled the Wall Street Settlement. Investment funds pay for many of the services provided by independent research firms in "soft dollars." Instead of receiving hard cash, research firms, including NDR, are often paid with credits (meaning they get to play at no cost on the stock exchange) for trading commissions, and the Securities and Exchange Commission considered banning such payments.

Seventy percent of the firms in the 2004 Investorside survey said they would consider closing shop if regulators were to ban soft-dollar payments. Relief came, however, on July 12 this year in the form of an SEC ruling that it's OK to be paid in soft-dollar commissions.

How does NDR, with $39 million in revenues, plan to continue its growth?

The number of large institutional investors is fairly limited; NDR has 1,000- plus clients on what's called the "buy" side, and Davis believes his company has pretty much maxed out on big institutional investors.

So the company is trying to go beyond pension and mutual funds by developing a new type of clientele: ETFs. Similar to index funds, but traded more like stocks, ETFs, or exchange traded funds, are gaining popularity in the financial universe. NDR, according to Davis, is systematically pitching research services to ETFs.

To NDR, the Wall Street Settlement wasn't the big promise it was for other research firms, because it never specialized in individual stock analysis.

"In a sense, we didn't want to do the settlement," Davis says.

However, NDR also began trying to make inroads on the "sell" side, offering quantitative analyses of individual stocks to large Wall Street investment banks. So far three brokerages have picked up NDR's new individual stock analyses.

Another growth spurt could come from getting a Wall Street investment bank to actually buy a stake in the company. The Wall Street firms, looking for a stable of low-cost but high-quality independent research they can offer to their clients, are scouting for minority investments, Davis says. The major advantage of partnering with a big investment bank would be a boost in marketing power: Hundreds of brokers work for the large firms-compared to the 13 working at NDR's Atlanta offices. Davis says he's had "several approaches," and that he is in talks.

Another way NDR figured it could increase revenues is by using its reputation and know-how to manage money on its own. Over the past three years, NDR partnered with high-profile "pots of money" such as Zweig Funds and Gabelli Funds to seek investors for two retail funds carrying the Ned Davis name.

But the money management activities have been a mixed blessing. For one, NDR has a squeaky-clean reputation at stake. Although Davis maintains there is no actual conflict of interest, combining research with money management has conflict-of-interest appearances built in.

Also, the funds didn't grow as expected, partly because the people who sold the fund weren't too interested in actually selling it because they were getting a smaller cut from selling the Davis Fund than their own funds.

"In our mind we didn't do anything to jeopardize our client relationship. But on the other had, what we were doing was competing with our clients. Our clients are money managers, and we drive into their markets. I've been overly cautious about this," Davis says.

Nevertheless, NDR continues to bet on some money management activities.

"We're trying to build this, with some corporate pension fund money mostly," Davis says. "We're just very careful about it."

Another area of expansion Davis says NDR is "heavily interested" in: foreign markets. Although one-third of NDR's clients are abroad, the analysis provided by the firm so far has all been based on U.S. data. So why not offer these foreign clients analysis of their home markets using data from the London Stock Exchange, or markets in Mexico City, São Paulo, Hong Kong, Frankfurt, Paris or Madrid?

Some of NDR's foreign clients "keep saying to us, we love your research in the United States, why can't you do the same thing for France or England?" says Davis. "There's a data problem, and that's what we're actively trying to solve. The second thing we've done is the China market. That's our next big area."

As they say, the sky is the limit.

Davis' 2007 OUTLOOK

You're in a pretty defensive position right now. Why? We're in a neutral to defensive position. The markets are at near highs, which is good. The Dow and the S&P 500 are at near highs. [The Dow closed at a high in October, after this interview.] But those [indexes] are dominated by a handful of very large companies, and the broader market is not making near highs. This is not a broader trend where everything is going up. I think that's why some people aren't celebrating that much here. Their own portfolios aren't making near highs.

What period of history would you compare our current one with? I think it has a lot of similarities with the late 1960s, early '70s.

So we should anticipate a crisis? Yeah. In 1968 we had had 20 years of great markets. One of the problems with very long boom markets is they breed excess. There was a long period when the market went sideways, after the bubble in 1968. It's possible we're in that same kind of environment.

Your take on the housing market? We were on the forefront on warning about the housing bubble. We talked about it a lot in the summer of last year. In a major report in October we said, 'Get out of homebuilding stocks.'

Unfortunately, Sarasota is one of the main areas where it was concentrated. Our numbers are as bad as anyone's. Interest rates have fallen so much there's a good chance that it may feel like a hard landing.

Affordability is one of the big problems here. Houses went up so much and the interest rates went up. Incomes weren't growing very fast-they're [houses] just not affordable for the average person. But we feel like in the last month, affordability has bottomed, and it's starting to go up. That's the first sign you're looking for that demand is stabilizing. That's the part we like. What we don't like is that the supply of homes for sale continues to go up. We really need to see that come down. You would look for homebuilders to cut their homebuilding back, and they have. So at this point we feel like it's going to be contained.

Overall, it may be a soft landing. The reason we say that is interest rates have gone down, home prices themselves have gone down countrywide, and people's income has gone up.

We're in a period of accelerated change. United States debt is skyrocketing, China has become our biggest lender, the IMF is going down the drain, developing nations are taking a more independent road. Should that be a concern for investors here? Globalization and the breakup of communism have changed the world. Now China, India, Russia and Brazil are leading the world economy that the U.S. economy has dominated for a long time. But you know, before that the British dominated, and before that someone else. Things change, and we still have a lot of things going for us in this country. Of all the developed countries, our performance is by far the best. One of the things that concern me is China and Russia. It's nice to have competitors that are also friends, which is what we had with Europe. Now we've got competitors that I'm not so sure about.

Is the permanent "War on Terror" bad for markets? There's a slight edge for peace over war. Some people say World War II brought us out of the Depression. It was a plus for the economy, and defense spending is a boost. But the record says the market does a little bit better under peace. In the 1960s and '70s the Vietnam War was unpopular, and it was causing conflict in the country and in the markets. We're in a situation like that. I don't think you can make a case that war is necessarily negative. But obviously, more popular wars are going to help the market more than unpopular wars.

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