Hedge Funds Select Their Favorite U.S. Analysts

Eric Sheridan, a UBS analyst who follows such Internet names as Google, Twitter and Yahoo!, cooled on the prospects for Amazon.com’s stock last winter, downgrading shares of the Seattle-based online retailer from buy to neutral in February, at $361.79. He identified myriad reasons why investors should be cautious. These included results of a proprietary survey showing that a $20 hike, to $99, in the annual subscription fee for Amazon Prime — the service that provides members with free streaming movies and music as well as two-day delivery on eligible products — could cause renewal rates to plunge from an enviable 94 percent to 58 percent. (Amazon.com announced just such a price hike the month after the analyst’s downgrade.)

Sheridan also warned that Amazon’s spending on such projects as the Fire Phone, cloud computing and media content was likely to “put profitability under pressure for at least the next couple of years.”

The analyst’s warnings proved prescient. In late October the company reported an earnings loss of $437 million for the third quarter, nearly 11 times the $41 million it lost during the same period one year earlier. By the end of October, Amazon’s share price had fallen 15.6 percent since Sheridan’s downgrade, to $305.46. During the same period the S&P 500 advanced about 11 percent.

“Eric was one of the first guys to get off the Amazon bandwagon,” cheers one hedge fund fan who asks that his name not be used.

Sheridan, a former hedge fund manager himself — he spent a decade at Jacksonville Beach, Florida’s Intrepid Capital Management and Chicago-based Citadel before signing on with UBS in 2012 — has been rapidly building an avid fan base among his former peers. “He thinks like a buy-sider,” says another manager, also insisting on anonymity. “There are 50 different data points and stories about Google that we could talk about, but Eric distills the stock down to what drives earnings and uses multiple valuation metrics to justify a target price.”

Although he didn’t earn a place on the 2014 All-America Research Team, Institutional Investor’s annual ranking of the nation’s top equity analysts, hedge fund managers insist that no one covers the Internet sector better than Sheridan. Nor is he the only analyst held in higher regard by this type of client. To find out who are their preferred research providers, Institutional Investor’s Alpha recalculated the results of this year’s All-America Research Team using only the votes cast by hedge fund respondents. J.P. Morgan leads the lineup for a second year running; its analysts earn a place in 37 of the 63 sectors that produced publishable results. Bank of America Merrill Lynch rises one rung to share second place with Morgan Stanley, which holds steady in that spot. These firms capture 33 positions each. Deutsche Bank Securities repeats at No. 4, with 22 positions, followed in fifth place by ISI Group, which rockets from No. 11 after increasing its team total by more than 50 percent, to 20. These results reflect the opinions of more than 1,000 hedge fund managers at nearly 400 firms that collectively manage some $925 billion in U.S. equities.

The table in the menu at right cites the analysts who finish in first, second and third places in each sector, plus runners-up (where applicable).

As hedge funds have grown larger, many have assumed the characteristics of traditional funds — including longer-term horizons, notes Brett Hodess, head of Americas equity research at BofA Merrill. Even so, hedge fund managers “oftentimes are adjusting their portfolios for short-term risks,” he says, and that whets their appetite for fast-changing news. “Traditional managers eye stocks for one, two or three years and are less concerned with immediacy — unless it’s a really big piece of news,” Hodess explains.

Nor is that the only difference between the two types of investors. “On average, hedge fund clients want to see and hear from analysts more frequently [than traditional fund managers],” he adds. “They really like to compare notes, dig down and get into the weeds.”

Along with picking winning stocks, BofA Merrill analysts are under strict orders to identify losers. At any one time, Hodess says, 20 percent of equities must be rated underperform — a policy that could endear the firm to managers of long-short and multistrategy hedge funds. “Approximately one third of stocks underperform, so we should be able to pick 20 percent,” he observes. “Otherwise, how are we helping our clients?”

Morgan Stanley “is not creating a product that is narrowly tailored to any particular style or type of investor,” declares David Adelman, who became head of equity research for the Americas in September. (He replaced Stephen Penwell, who now oversees the North American Stock Selection Committee.) Adelman cites a pair of proprietary research products — Blue Papers and AlphaWise — that resonate with all asset managers.

Blue Papers are exhaustive reports on global business trends produced through a collaborative effort “across sectors and geographies,” says Adelman. Examples include analyses of financial reform in various global markets, railroad transport of crude oil, development of subsea infrastructure and many others.

AlphaWise is Morgan Stanley’s market intelligence unit. Its surveys bolster research, and the group frequently provides bespoke market studies for the firm’s analysts. For instance, Adelman says, the unit might be engaged to investigate market penetration of a new drug. “You could hire somebody to scrape the web and get information,” he says, “but you need benchmarks on whether doctors are prescribing the new product or how long they keep patients on the drug.”

ISI Group, whose acquisition by Evercore Partners was completed in late October, spent the past five years aggressively expanding from a boutique macroeconomic and policy shop to one that also produces fundamental research on 12 industry sectors, including energy, financial services, machinery and software. The firm’s analysts blend macro and micro research, according to Vinayak Singh, a member of Evercore ISI’s executive committee and former ISI Group president. For example, a biotechnology researcher might enlist a quantitative analyst on a conference call to discuss whether an unusual drop in a stock’s price means that “a correction has run its course,” he explains, or consumer and technology analysts might join forces to talk about how online sales affect brick-and-mortar stores.

Although the firm’s lead economist, Ed Hyman, is the undisputed champion of the All-America Research Team — he has been No. 1 in Economics for the past 35 years — he takes a back seat to Deutsche Bank’s Torsten Sløk in the estimation of hedge fund voters. These clients can be demanding, and when they request information, “I’ll take up their questions immediately, not in two or three days,” Sløk says. “I’ll give hedge funds VIP service.”

In late October the economist forecast that job growth should pick up, along with inflation. “Headwinds are fading in the housing market, for consumers, and in the banking sector,” he wrote to clients. “That is why employment growth should accelerate. We will reach full capacity and full employment and start to see inflation.”

The U.S. Department of Labor reported in November that the U.S. economy added 214,000 jobs the previous month — the ninth consecutive month that more than 200,000 jobs were added — and the jobless rate ticked down to 5.8 percent, a six-year low. In addition, overall compensation in the private sector increased by 2.2 percent year over year in the third quarter. Fixed-income investors should take note of this wage acceleration, Sløk says, because it’s something the Federal Open Market Committee will take into account as it considers when to raise interest rates. Those who argue that “rates will be low forever,” he adds, are overlooking the impact of compensation growth — at their peril.

When it comes to rolling the dice on casino stocks, Sløk’s colleague Carlo Santarelli is the hedge fund managers’ choice in the Gaming & Lodging sector. “This is a data-heavy industry,” he says. “I don’t have anything that anyone else doesn’t have. It’s just trying to be as up-to-date as possible.”

Thematic pieces are one of his hallmarks. A June special report on the expansion of Macau’s Cotai Strip, for example, explores the prospects for the properties under development, some of which will open as early as next spring. His analysis also includes stock ratings for participants: Wynn Resorts (buy), Las Vegas Sands Corp. (buy) and MGM Resorts International (hold). “The goal of the report,” Santarelli says, “is to make out what the landscape will look like and the impact on existing operations.”

Back in February the analyst highlighted his buy rating on Chicago’s Hyatt Hotels Corp., at $49.39, citing such positive trends as higher occupancy and room rates. The stock had shot up to $59.22 by late October, for a gain of 20 percent that bested the sector by 19.3 percentage points.

For a holistic view of Homebuilders & Building Products, hedge fund managers say they prefer independent analyst Ivy Zelman, a member of the All-America Research Team Hall of Fame. The founder and CEO of Zelman & Associates oversees a 12-member team that covers every aspect of the homebuilding industry, from mortgage lenders and title insurers to landowners, real estate investment trusts and government policymakers.

Lately, she has been taking heat for her upbeat outlook on builders. Her proprietary index of 24 stocks is down 5 percent year to date through October. Nonetheless, “I feel very confident we’ll get an upcycle, and unlike the secular bears, we’re bullish,” Zelman says.

Americans aged 20 through 34 — part of the so-called Millennial generation — are enjoying the highest employment growth rate in years, she notes, and that means they are increasingly able to afford homes. Add in a housing shortage, plus signs that credit is becoming more accessible as banks and mortgage lenders are becoming more flexible, and the case for a resurgent sector is closed, the analyst insists.

Recommended homebuilders include Miami’s Lennar Corp., owing to its “best-in-class” management, she says; PulteGroup of Atlanta — “a great turnaround story”; and Toll Brothers of Horsham, Pennsylvania, which has the “greatest exposure to affluent buyers and condos.” Zelman also has buy ratings on Deerfield, Illinois–based Fortune Brands Home & Security, a maker of cabinets, faucets and windows, on the strength of its “return-focused management team”; and Mohawk Industries, a flooring manufacturer headquartered in Calhoun, Georgia, thanks to its “substantial success with integrating” its April 2013 purchase of Italian tile maker Marazzi Group.

Zelman “has put together a deep research team,” says one supporter. “She’s got probably the best housing research team on the Street, period. Over the years she’s called the cycle right.”

— Paul Sweeney