Editor's Note: The article below was originally featured in Magazin, one of Germany's largest and most influential business magazines. It has been translated from German into English.
A few hours after Russian troops launched their war of aggression on February 24, stock indices around the world went into free fall.
It’s early morning on the Eastern Seaboard. From his home in Connecticut, Keith McCullough (47) dials into the daily research call of his invesmtent research firm, Hedgeye.
Hedgeye’s modus operandi: "Analysis on the level of the best hedge funds, for everyone".
Of course, McCullough did not foresee the attack on Ukraine – but he did foresee the precipitous fall in stock prices. The former hedge fund manager had been preparing his clients and subscribers for a stock market crash since the beginning of the year. His forecast at the time: an economic decline in the U.S., Western Europe and Russia – accompanied by stock market crashes in all three, starting around March. All it would take, he said, was a small trigger.
His advice based on his outlook: buy gold, buy U.S. dollars – and bet against overvalued tech stocks.
In recent weeks, the prices of many tech stocks have already collapsed. Now the catalyst for the market-wide plunge has arrived.
"We are part of a small community that is prepared," McCullough says of his research team and subscribers. The former Yale University hockey captain strives to create a team atmosphere, akin to a dressing room before an important game. For him, it's "Hedgeye Nation" against the "Old Wall” Street.
And this round goes to him.
Anyone who believed the optimistic bank analysts has suffered an over 15 percent drop in the Nasdaq since November. McCullough’s clients, on the other hand, now need one thing above all else, "patience”, he says.
The stock market decline is likely to continue for the time being, predicts the Hedgeye boss. The war in Europe is hitting the global economy and markets at a moment of weakness. The U.S. economy, which grew by almost 7 percent in the fourth quarter of 2021 (partly due to government stimulus checks to citizens), is currently experiencing no growth at all. Furthermore, markets are groaning as Federal Reserve Chairman Jerome Powell has announced plans to raise interest rates amid high inflation.
Most analysts and investment strategists at major banks, on the other hand, remained optimistic until it was too late. Goldman Sachs equity strategist Peter Oppenheimer (58), who earns a million-dollar salary for his services, was still predicting 8 to 11 percent total returns for shares in the U.S. and Europe in mid-January.
The 2022 earthquake on the stock market exposed a glitch in international capital markets – for which retail investors are paying dearly. The so-called equity experts at the major banks must account for the investment bankers within their own firms. The investment banking arm of a bank benefits from investor optimism, as they look to advise businesses on raising capital and going public via IPO.
The conﬂict of interest is a fundamental one: the research department of a Wall Street bank is a loss-maker that is cross-subsidized by the capital markets business. Whoever earns the money sets the rules. Per a Harvard Business School study in 2011, research analysts at major Wall Street firms are not paid according to the accuracy of their buy recommendations, but for their reputation as star analysts and for bringing in mandates for the investment bankers.
Whose bread I eat, whose song I sing: The EU directive MiFID II, which was supposed to resolve the conflict of interest, has done nothing of the sort. Since 2018, banks are no longer allowed to offer their analyst studies to customers as a gift (in the hope of winning fee-generating mandates), but are required to sell their research. However, because customers don't want to pay the true costs, the major banks offer the studies at steep discounts. Thus, the conﬂict of interest persists. Sell recommendations on a stock, or warnings of a stock market crash, are bad for business, and therefore extremely rare.
Something has changed, however: Retail investors no longer have to live with the expedient optimism of the major banks and their analysts. New players have emerged that offer independent analysis, unbridled by conflict of a capital markets arm. Supported by automated checks, it is growing – and is also being used by major investors.
Just Like The Bank - Only Better
One of McCullough's listeners on the day when the war in Ukraine started, as he almost always does at 1:45 pm European time, was Jörg Märtin. The advisor to the family oﬃce Avalon Hill Management was sitting in his office in Lugano, Switzerland, watching "The Call," the morning show hosted by McCullough and his dozen managing directors. Each of them contributes what the news is from their industry and what to expect from it. "To me, it's like the "Morning Call" used to be in my days as an investment banker – except customers never got to listen in," says the longtime JP Morgan employee. "No bank offers that to clients – even though they charge much higher fees."
Hedgeye is the only research provider Märtin pays for. The smallest subscription available to retail investors costs $29 a month. Institutional investors pay tens of thousands or even hundreds of thousands of dollars a year, according to Hedgeye President Michael Blum. The German, who once launched PayPal in Germany, runs Hedgeye together with former Yale classmate McCullough.
For Märtin and the family whose assets Avalon Hill manages, "It doesn't make sense to hire your own industry analysts." One reason for the high quality of the Hedgeye analysts: they are paid according to their success rate, unlike at banks. The importance of having the right incentives is exemplified by the tech quake of 2022: McCullough kept his customers away from Tesla and Meta (Facebook).
Of the 58 Facebook stock analysts tracked by financial data provider Reﬁnitiv, on the other hand, only one had a sell recommendation when the price plunged more than 20 percent on February 3. The company disappointed with its forward outlook. The share price landslide wiped out roughly $300 Billion in market value.
The tech quake was also felt on the DAX. On February 10, the price of food and grocery delivery service Delivery Hero plunged 30 percent after company CEO Niklas Östberg (42) announced even greater losses to investors. Bank analysts had let investors down then, too. Of 24 analysts, 20 recommended Delivery Hero shares as a buy in November 2021. The average price target was 160 Euro, four times off.
Such euphoria for a company that burns almost twelve cents of capital for every euro of revenue seems grotesque, but it was beneficial - at least for the banks that employ analysts. Because it is precisely because of this cash burn that Östberg constantly needs new capital for his expansion dreams – which means lucrative business for the bankers.
These two factors came about when Delivery Hero raised around 1.2 Billion Euro in fresh capital in January 2021, in exchange for new shares at 132 Euro. The two leaders of the banking consortium at the time, Morgan Stanley and J. P. Morgan, still had price targets of 155 Euro and 139 Euro for their good-standing customer, even in November 2021.
Wall Street managers stuffed their pockets with ever-higher share price targets and the stock market boom – all that is over for the time being. Now imprudent shareholders are having to settle the bill for the party.
The same applies to Teamviewer. The provider of remote computer maintenance went public in 2019 and issued shares at 26.25 Euro. The proceeds of 2.2 Billion Euro went to previous owner Permira, a private equity firm. Joint book runners Morgan Stanley and Goldman Sachs each received $35 Million in fees, reports financial data provider Reﬁnitiv. Joint book runners Barclays and Bank of America collected $18 Million each.
The annual salary of Teamviewer CEO Oliver Steil (50) has risen to more than 40 Million Euro – a figure that only Delivery CEO Östberg (45 Million Euro) and former Linde CEO Steve Angel (66) (53 Million Euro) have reached in the past. It's hard not to lose traction. Steil thought it would be a good idea to initially enter Formula 1 sponsorship with the company (with the Mercedes-AMG team). Then Teamviewer signed on as the main jersey sponsor of Champions League soccer contender Manchester United, which generates more revenue than its new sponsor. Manchester United approached Teamviewer, Steil revealed to the "Süddeutsche Zeitung" a year ago, since: "We already support the local handball league team Frisch Auf Göppingen."
The share price doubled by the summer of 2020, to almost 55 Euro. Since then, it has crashed to under 15 Euro.
Permira and Teamviewer were extremely attractive customers for banks. As a result, there was not a single sell recommendation among twelve analysts until December 2020. As late as January 2022, there was only one sell recommendation from bank analysts, even though the share prices had already been in free fall for months.
The analysts in the service of the consortium leaders of the Teamviewer IPO were very optimistic: Goldman analyst Mohammed Moawalla only withdrew his buy recommendation in June 2021 and lowered his price target to 37 Euro; still much too high, compared to the ongoing price crash. Morgan Stanley analyst George Webb acted even later: It was not until mid-October 2021 that he lowered his recommendation from "Overweight" to "Equal Weight". He also cut his price target by more than half, from 48 to 18.50 Euro. The price had long since reached 13 Euro.
Analysts ought to know to whom they owe their salaries, and why. EU Directive MiFID II reform has failed. The compulsion to charge money for stock analysis brought no improvement.
"The EU failed to achieve its ’good goal’ of making research independent of other banking activities", says Dieter Hein (59) co-founder of Fairesearch, an independent Frankfurt-based provider. "The big U.S. banks have undermined that."
The major banks initially tried to sell their research to investors for six-figure fees per year. But no one wanted to pay that much. Eventually, the Wall Street brokers complied, and since then they often sell their entire research for 10,000 Euro per annum.
"The big banks are dumping prices", Stuart Graham complains. "They are the big winners of MiFID II." Graham knows the banking business better than anyone. He was already a one-of-a-kind fearless and opinionated analyst in the 90s in the employ of HSBC and JP Morgan. From 2001, he worked for Merrill Lynch and became one of the most respected critics of bank executives during the financial crisis.
In 2009, he and several colleagues founded Autonomous Research in London. In 2018, the year MiFID II launched, the Autonomous founders sold their company to the financial group Alliance Bernstein.
"The job of a stock analyst is no longer as attractive as it used to be", says Graham during a talk in a London branch of the sandwich chain "Pret A Manger", while a squad of construction workers nap on the benches next door. More than the lack of time for three-course lunches, the loss of quality in his sector bothers Graham. "The experienced analysts have moved on to the mutual funds or venture capital funds."
There are two major trends: Analysts are becoming increasingly inexperienced and younger – and the work is becoming digitized.
An experienced stock analyst makes 193,000 Euro in London and 145,000 Euro in Frankfurt, data from consultant WTW shows. Traders or merger consultants are paid far more. In an internal comparison, analysts are falling further and further behind. "The salaries of other investment bankers have increased more than those of stock analysts since the financial crisis," says Florian Frank, Head of Work & Rewards Germany at WTW.
Some competitors hardly need any human analysts at all. Computer-generated stock reports have been around for a long time, but they have received little attention so far. Wrongly so.
Robots have a much better hit rate than bank analysts, shows an October 2021 Indiana University study, with robo-recommended stocks yielding 4 to 5 percentage points more return per year than stocks recommended by analysts.
The robots are not susceptible to human bias, are not influenced by conflicts of interest, and have no incentive to ingratiate themselves with the executive boards, the economists conclude. They would more often include information that companies have well hidden in their sprawling financial reports. And they are not as obsessively optimistic: Humans recommend every second stock for purchase - the rigorous computer only every third. The robots gave sell recommendations on a quarter of the stocks, while the humans did so on only 6 percent.
One of the research providers in the study who lets the robots do the groundwork is David Trainer. He once racked his brains over long corporate financial reports as a stock analyst at Credit Suisse. Trainer had developed a model to detect accounting tricks and correct euphemistic "adjustments" to earnings ratios. Then the accounting geek moved to his hometown of Nashville and founded New Constructs.
Instead of going through the financials himself, he now feeds them into his computers. "Others still work with a shovel, we come with a bulldozer", says Trainer. It takes a person eight hours to seriously work through the average 250 pages of an annual report, including footnotes. "Hardly any analysts have time for that anymore", he says. Trainer's program does it faster and more accurately: It rates stocks with five categories from "very attractive" to "very unattractive." Quite a few professional customers also pay for the data.
Robot analysts who search for capital destructors are also installed in London's Canary Wharf banking district. The start-up Forensic Alpha resides there, high up in the One Canada Square office tower. The signs of the stock market boom are still omnipresent at the end of February: In the shopping center associated with it, screens are showing advertisements for crypto-tokens ("NFTs"); one of the most prominent shop ﬂoors is rented out to the once-celebrated fitness bike manufacturer Peloton, whose stock is itself an example of how out-of-touch managers and analysts trigger a price fireworks followed by a crash.
The software looks for signs of manipulation, fraud or aggressive accounting in 4,000 companies in Europe and the U.S. This results in a risk rating from ten (many alarm signals) to zero (none). Most of the customers are hedge funds, which are always looking for crash candidates for short bets.
At launch in 2015, Beevers employed half a dozen analysts. He kept only one and instead hired almost 40 programmers in Hyderabad.
Just how valuable software can be was demonstrated by the chemical group Clariant on February 14. The share price plummeted by 20 percent at times that day after the Swiss company had to postpone publication of its annual report: Auditor PwC had refused to sign off, following a five-month secret special investigation. It had been triggered by alarm calls from several employees. Apparently, some colleagues manipulated figures, admitted Clariant CEO Conrad Keijzer (53).
Forensic Alpha had already sounded the alarm in April 2021. "Our systems had detected that Clariant had been building up accruals in a suspicious manner for years, which they then gradually released," former PwC expert Beevers explains.
His robots also track down companies that show high cash reserves for years and yet are in debt. One example is Wirecard, where it turned out that the cash was never there.
But in the Wirecard case, it was a team of human analysts who tracked down the fraud back in July 2014 and issued a red flag alert and a short recommendation. Their headquarters are located next to a railroad bridge and the shisha bar "Sexy Fish and Shish" in the unsophisticated south London district of Clapham. The doorbell simply says: The Analyst.
Chasing Thieves by Hand
In an open-plan office with several desks, Mark Hiley (41) places himself in a sofa corner and explains his business model: "We deal with fraud, bad accounting and structural decline."
The Brit began his career in 2001 at the U.S. fund group Fidelity, and built up the London office of a U.S. hedge fund with a Fidelity colleague from 2004. After that, the idea of short research for hedge funds was born.
"We thought competition from banks was pretty weak," Hiley says. And hedge funds pay decently, especially for short ideas. Despite the drop in prices over the past few years, The Analyst has been able to maintain its rates.
"Even before MiFID II, we were much cheaper than the competition; since the reform, we have become premium providers." He employs seven analysts. "Research is expensive. for the Wirecard studies we sent colleagues to India."
Hiley could carve a few notches in his pen; the list of bull's-eyes is long. "We had seven zeros." In other words, price targets of zero, in many cases fraud. The Analyst came across the accounting manipulations at furniture retailer Steinhoff at an early stage.
Hedge funds provide a third of the revenue, investment funds another third, and family oﬃces the rest. Half of the customers are based in London. Remarkably, Germans are hardly to be found among the subscribers. At the same time, Hiley has always had German short candidates on offer. After Teamviewer, the last one was the online dealer Auto1 (Wirkaufendeinauto.de) in September 2021. Reasons: the high cash burn, low market entry barriers and the high valuation. At the time, the bank analysts gave eight buy and no sell recommendations. Since then, the price has collapsed by two thirds.
Following the "exaggerated drop of the share price" (Hiley), The Analyst has withdrawn its short recommendation. Instead, two bank analysts now recommend selling the share. At rock-bottom prices.