A few weeks ago I attended the InfoSec World Expo in Orlando, Florida where I had the privilege of listening to and learning from some of the smartest people in the information security industry.  Among an overabundance of financial service professionals were hackers, government intelligence officials, private sector security consultants, researchers, and authors.

I was surprised by both the number of financial service professionals in attendance and the spectrum of their employers.  The Federal Reserve, bulge bracket banks, regional banks, and online and full service broker dealers.   Yet there was a noticeable lack of industry representation from software and technology vendors that support financial service firms (FinTech).  Nowhere could I find anyone from a capital market technology vendor, or a security exchange, or a clearing house.  I struggled to understand why these providers of strategic services so vital to the financial community were so startlingly absent from this event.  Are these FinTech providers insulated from the threats that the financial service providers and the government in general have succumbed to over the past few years?

There was a similar dearth of CEO’s, President’s, CIO’s or CTO’s.  Most of the attendees were direct reports of the technology leadership and almost no strategic or client focused representation was noticeable.   This brought me to my second question – Are security issues in today’s world not important enough for the most important?

I hope to answer both of these questions within this brief article.

Roger Cressey, a well-known terrorism analyst, gave a rather animated keynote.  His argument, similar to many others at the show, was that the United States Government is ill equipped to deal with the growing threat of cybercrime.  Moreover, the private sector may be even more poorly equipped.  Most of the cyber crime is not coming from kids in a basement or a lone wolf, said Cressey, but rather from foreign governments, even those considered close US allies.  Highlighting cyber attacks such as the Navy’s F-35, Google’s breach in 2009, Operation Trident Breach in 2010, Nasdaq and London Stock Exchanges breaches in 2010,  and the European Union headquarters attack in 2011 cemented his argument that no one is really ready for growing threat of cyber terrorism.

Others at the conference discussed the cloud and its ramifications on security, particularly the highly sensitive information possessed by financial related services.  Many security professionals argue that moving information and services to the cloud to cut costs is a bad idea, with most of the companies not having a contingency plan for major breach.  Furthermore, once companies move information to the cloud, bringing information back to their own local data centers is a problem few executives can answer.  Overall, most argued that expense related technology changes that impact security should be done on a very select and very diligent basis.

My third take away from the conference was that many of the cyber attack are not direct attacks on corporate infrastructure, but typically well placed “phishing” attempts where corporations are infiltrated from an employee’s computer through file sharing or social media related sites.  In this situation with limited security infrastructure to help neutralize these types of cyber attacks, diligence is your best weapon.  My discussions with industry professionals informed me that these attacks are becoming more complex and harder to detect, to the point that they are almost impossible to prevent.

In the month since the conference I have had time to reflect and speak with many colleagues, clients, and friends about security and the issues addressed above.  Most agreed that cyber security is becoming a major challenge and most also agreed that nothing will get done until there is a major attack, whether it be a breach where substantial information is stolen or a freezing of highly sensitive and important infrastructure.  Most also agreed that these issues are not on the agenda for most C-level executives because they have not been important enough.

This is where I would like to make an argument on value.

Many companies are occupied with thinking through strategy, planning product initiatives, executing on top line growth and eliminating unnecessary costs, all with the intent of driving increased shareholder value, and rightly so.  Up until most recently, the major concern for FinTech companies, the goal that would facilitate all of the preceding goals mentioned, was simply ensuring uninterrupted service.  However, today the operational risks, although perhaps not well identified by most, are game changing and demand attention.

Imagine that a major FinTech company that archives client information, including family holdings, and brokerage commissions, is breached and the securities stolen.  You can imagine the destruction in value, lost clients, major shakeup in C-level management, negative media exposure, and the quickly deteriorating share price.  The more important question is not related to the individual firm, but rather the industry in general.  What would happen to the sector’s value?  Would everyone experience a decline in capitalization?  Would the smaller more nimble entrepreneurial company experience an even greater decline in value – a flight to quality?

It seems more than possible that a major breach to one FinTech company can have a systemic effect upon the entire industry.  The only way a firm can be protected from this value erosion is to ensure that they have well documented and strategically aligned security program, with full C-level participation.

Although the threat of a flight to quality is ever present, it seems that entrepreneurial companies have an advantage in ensuring a well thought out and strategically aligned security program.  Unlike most of the large FinTech providers, these smaller FinTech companies are more nimble, with fewer infrastructure needs, allowing the instillation of a viable program that addresses cyber security issues in the manner above.

Cybersecurity and cybercrime are game changers for FinTech companies, yet many C-level executives are currently unaware of the real risks they pose and some will unfortunately fall into their grasps.

Bankers typically discuss how to assist companies with increasing shareholder value through growth, but in this case it seems important to discuss how you may save value, or even create value, in a way that may have been previously overlooked.  It’s my advice that you reconsider your security strategy, re-analyze your needs, re-consider the ideas from the IT staff, and, most of all, engage the entire organization in your plans.

As I have been arguing over the past 6 months, the oligopoly of the credit ratings agencies will probably not be sustained in the long term.  Today, we have a new and welcomed competitor, Kroll Bond Ratings Agency Inc.  Founded by Jules Kroll, who has a background in corporate investigations, Kroll expects to dig deeper in credit ratings, moving beyond issuer information.  Kroll expects to lever his son’s security firm K2 Global to assist in uncovering anomalies or areas of risk that lie off the balance sheet.  Kroll is not a new company but rather the business evolution of Lace Ratings, which the company acquired in the summer 2010.

Over the past few months we have seen one new entrant and two acquisitions in the ratings marketplace:

New entrant: Meredith Whitney’s Advisory Group

Acquisitions: Morningstar acquisition of RealPoint LLC and Kroll’s acquisition of Lace Ratings.

These seem like three moves in an industry that is ripe for change, both organizationally and technologically.  The anticipation is that change will continue to happen, with ratings agencies acquiring more analytically sound and advanced mathematical ratings capabilities and many of the investor research firms which have such capabilities moving into the ratings agencies marketplace.

It seems like the only barrier to entry standing in the way of new product innovation  is related to the selection process for a new Nationally Recognized Statistical Rating Organization. Today, the SEC provides unclear information related to the application and selection process.  Once the SEC gets out of its own way and clears the path for more competition, we should feel confident that this marketplace will erupt in many different areas, creating quantitative qualitative, industry specific and many other different types of ratings.

Only time will tell but the trend is showing a positive move in the right direction.

Articles of Interest:

http://professional.wsj.com/article/SB10001424052748703951704576091683201498122.html?mg=reno-secaucus-wsj

http://www.bloomberg.com/news/2010-12-08/credit-ratings-can-t-claim-free-speech-in-law-bringing-risks-to-companies.html

http://professional.wsj.com/article/TPPRN0000020110119e71j004so.html

http://corporate.morningstar.com/us/asp/subject.aspx?xmlfile=174.xml&filter=PR4482

Over the past few months, I have been informing you about the trend we are starting to see in the independent investment research marketplace. My past posts have called for the independent investment research marketplace to consolidate for a few reasons:

1. Discretionary spending on independent investment research is down due to the awful effects of the recent crisis. – causing revenue sustainability and growth challenges for the smaller research providers.

2. The number of hedge and mutual fund professionals is down from the height of the market in 2007 – further challenging revenue sustainability and revenue growth.

3. Independent investment researchers will continue to be threatened by issuer generated lawsuits – to offset these challenges, firms will merge to create a stronger balance sheet.

4. The recent challenges of the credit rating agencies will provide an opportunity for independent investment research providers to enter this marketplace. Considering these propositions, this memo is to once again reinforce our original hypothesis and to provide a glimpse into the past few weeks’ events. _________________________________________________________________________________

This week much coverage has been given to the impending indictments of insider trading across the financial services industry. As one may expect, the typical cadre of hedge funds and analysts are being mentioned among those possibly indicted. However, recognized names in the independent investment research and expert network business have been rumored upon, as well. This presents a unique difficulty for these businesses. Institutional and retail trading, brokerage firms, understandably sensitive to any controversy, will most likely sever ties to any research or expert network providers embroiled in the impending investigation, despite the very strong possibility that many of these firms will be cleared of all charges – in the long run. Unfortunately the long run is just too far in the distance for many of the smaller independent investment research firms.

Impacted by the drop in discretionary investment research spending, the drop in fund professionals and the elimination of federal funding, many of these firms will have a severe challenge of making it through to next year, despite the fact that their research may be industry or market leading.

In addition to the most recent downbeat press, there are signs of vitality in the investment research marketplace as well. Most recently Meredith Whitney, the previous ¬Oppenheimer & Co. banking analyst who predicted the credit crisis, announced that she plans to alter her independent firm into a nationally recognized statistical rating organization that will rate debt and will compete with Standard & Poor’s, Moody’s and Fitch.

With the yet unknown regulations that will impact the credit research marketplace, it is still too early to tell if the move to become a NRSRO agency is a potential avenue for many of the smaller investment research firms. What can be taken away from this is that the investment research market will change, some firms will go away no doubt, some will merge and some will be acquired – the open question is who will win and who will lose

My overall hypothesis is that the independent investment research marketplace is finding its way amidst the previous market turmoil, recent and unwarranted issuer retaliations, the end of the Global Settlement monies and the declining number of investment management professionals.

Independent investment research has a market size estimated at about $2 billion and growing, and represents approximately 250 companies in the United States. Yet I have been noticing a consolidation in the marketplace: companies between $8- $20 million in revenue have faced serious challenges achieving their next level of growth. The decrease in the number of traders and fund managers, coupled with the decrease in discretionary spend of retail investors seeking alpha, may have temporarily thwarted the upward momentum of both leading and average firms. Although the end of the Global Settlement has not impacted many of the research firms, it has created a hole for some of the larger providers.

To offset some of these challenges, investment research firms are looking to become multi-faceted by enlisting qualitative, quantitative, and expert network services, integrated within multi-asset class offerings. This is a direct attempt to increase competition with the larger research providers, such as Morningstar, S&P, MSCI, Risk Metrics, Moody’s, Thomson Reuters, IHS and Gerson Lehman.

In addition, I have noticed some firms are taking advantage of the recent challenges facing the credit rating agencies by entering this marketplace, albeit cautiously. Lastly, I have noticed that some firms have realized that a larger balance sheet can help sustain them in a down market and when dealing with adverse situations, such as “issuer retaliation” a common concern throughout most of the investment research marketplace.

It is my opinion that with the recent credit rating agency concerns, the recent sell-side research issues, and the conflicted activities of independent auditors that over the next few years, independence within the marketplace will return to prominence.

However, despite my bullishness on the industry, in the near term I see continued consolidation with companies seeking greater sales and distribution systems, larger balance sheets, and diversified offerings leading the way. Companies that are at the apex of the growth curve, those that are at the crossroads of raising more capital for infrastructure and hiring a larger sales force will be most favorable for an exit by a larger strategic provider.

Compared to the second half of 2009, the first half of 2010 has shown 40% and 20% increases in Price to Revenue and Price to EBITDA multiples, respectively. I believe these attractive movements in multiples will only accelerate consolidation in this industry.

The strategic acquirers that have been active in this marketplace are those you might expect, such as Morningstar and MSCI Barra but media conglomerates have also been expressing interest in this market. I have seen some of these firms purchasing their way into the investment research business. It is not far-fetched to see social media companies such as LinkedIn purchase Expert Network Providers and or dabble with equity and or fixed income research. For example, SourceMedia has recently entered the independent investment research business with the hiring of Jim Moore, former CEO of Highline Financial. The continued interest on behalf of media companies to diversify their portfolios into research will most likely gain traction as such businesses are not associated with ad revenues or steep correlations with marketing spending.

In addition to media companies, market data providers and analytics companies without news organizations also find great value in independent investment research providers. Most recently, FactSet’s acquisition of MarketMetrics, Thomson Reuters acquisition of Asset 4, and Point Carbon and Morningstar’s acquisitions of Old Broad Street, Aegis Equities Research and Realpoint LLC support this point. Other financial information providers, such as MSCI Barra, will continue to find interest in data analytics and quantitative research firms, as evidenced by their recent purchase of Risk Metrics.

Overall, I am bullish on the independent investment research marketplace long term, yet cautious over the next few years. Only time will tell, but it seems that with the consolidation in the industry, the higher quality independent investment research providers with deep domain knowledge, strong intellectual property, and strong margins will be acquired and those with less than stellar margins and limited access to sales distribution may find it challenging to compete.

Luigi D’Onorio DeMeo

Your name does not have to be Nouriel Roubini, Paul Krugman or Ben Bernanke to understand that the United States economy is not faring so well these days. Still recovering from the most severe financial crisis since The Great Depression, the economy is plagued with uncertainty related to costs associated with regulatory reform, a consumer that prefers to save rather than spend, and potentially higher income, dividend, and capital gains taxes.

The “headwinds” for the market and ultimately, a CEO are blistering. These executives are struggling to enhance shareholder value as costs have been slashed and final consumer demand remains weak. With historically high cash balances and a limited appetite to pursue new ventures, some CEO’s are turning to mergers and acquisitions (M&A) as a means to acquire new technologies and services that will enhance their footprint in the market, yet at the same time provide the opportunity to realize further cost synergies and enhanced distribution opportunities.

Most recently we have seen M&A activity increase with BHP Billiton’s hostile bid for Potash, Intel’s acquisition of McAfee, First Niagara merging with NewAlliance Bancshares (biggest US bank takeover since 2008), HP and Dell’s bidding war for 3PAR, and HSBC’s stake in South-Africa based Nedbank. According to Bloomberg data, deals in August will total $285 billion, close to the $297 billion of deals in August of 2007.

There seems plausible four main reasons for the recent M&A flurry:

1. Anemic economic growth in developing countries, limiting revenue expansion and potentially bottom line growth after expenses have been aggressively cut. The limited growth is attributed to an apprehensive consumer and unforeseeable regulatory future created by policy leaders.

1. Excessive cash on corporate balance sheets are due to lack of demand or confidence, leading to hesitancy to hire additional workers or increase capital expenditures. Shareholders demand that cash be invested in current or future businesses, not remain as reserves.

1. Low borrowing costs coupled with low earnings rates on corporate cash lead to low cost of capital and inefficient interest gains on cash.

1. Executives are not expecting a double-dip recession, but instead a slow growing economy that forces them to diversify or grow revenues and margins through M&A efficiencies.

Underlying these deals, there seems to be a consistent pattern developing. BHP Billiton, the world’s largest mining company is attempting to buy Potash to enhance its emerging market presence with Potash’s investments in China, Chile, and India. Intel’s acquisition reflects a chip maker acquiring a security company to supposedly enhance its top and bottom line while growing margins through synergies. HSBCs acquisition of Nedbank is just another attempt of an established company searching for growth in emerging markets.

While M&A activity is normally bullish for stocks and the economy in general, many experts believe as though these deals are not for the right reasons. Most of the acquisitions reflect an attempt to grow in other countries. This reiterates executives’ view of the weak US economy and the need to diversify away from a sluggish revenue stream. In August of 2007, an extraordinary amount of deals were done correlating closely with a stock market and economic high or top.

Many market commentators will use the M&A flurry to describe a negative catalyst where CEOs and executives tend to be late in timing markets and can invest capital at the height of the market rather than prior to a boom. I take a slightly different view and see the deals completed as a mixed revelation of confidence in the strong emerging market growth versus tepid growth for developed economies. While companies are admitting that domestic growth is fragile, they are confident enough to finally deploy capital with confidence that they will receive a higher yield on their investment than current interest rates on cash balances.

Corporations are also in disagreement with the market regarding the battle of bonds versus stocks. Companies believe stocks are too cheap and this is reflected in their hesitance to use stock to finance deals. Normally, businesses issuing equity for financing usually relates to a management’s belief that their stock is either overvalued or at fair value. Debt and cash are inexpensive avenues to raise capital and this phenomenon was most recently exacerbated in IBM’s ability to sell 3 year paper for just 1%.

I believe that the “headwinds” for the market and the economy that caused the near 20% decline in equities and recent soft economic data are suddenly becoming “tailwinds” that can rejuvenate stronger and more sustainable growth. Since the equity market decline and fixed income rally that started in late April, many economic and market variables have changed. The 10-year treasury yield that was pressing above 4% currently yields close to a record low of 2.40%, The Fed that was previously readying to withdraw liquidity in the market, is now on the cusp of further Quantitative Easing. Also, the dollar strength that was experienced months ago has started to fade as the greenback has erased half of its gains against the Euro, and finally, Crude Oil that traded around $85-$90 per barrel, currently rests around $73 lowering gasoline prices and allowing more disposable income for consumers. The variables are stimulating in nature for the consumer and businesses and it possible that CEO’s are taking note of that and investing in M&A.

Ultimately there is no debating that US economic data has been soft but I feel as though the scale has tipped far enough where the variables that drove economic growth in 2009 have corrected themselves to a currently favorable position. CEO’s are starting to invest in future business rather than continue to hoard cash. This allows me presume that the recent M&A buzz reflects that companies believe in a recovery rather than a recession and therefore to be cautiously optimistic with regards to previous impediments now becoming catalysts for growth.

In many respects my thoughts are in favor of free-market ideals, yet only when those who we are competing against are doing the same.  In many respects my thoughts have a mercantilist stance as well, considering moving away from our current stance as overseer of world events to a participant in trade, a country who minds their own business and focuses on growing GDP, increasing innovation, decreasing domestic poverty and increasing domestic education.

A quick entree into the upcoming articles, you can see where I am headed with the following quotes in the Star Ledger yesterday.  

http://www.nj.com/business/index.ssf/2010/09/theres_no_simple_solution_to_j.html

Cheers,

Chris

Over the past twelve years, the markets within the United States have been plagued with research analysts, auditors and now credit rating agencies who were influenced to communicate information that was less than truthful.

Regulatory changes were implemented due to each of these situations, and while they addressed some of the more pernicious practices, they have not fundamentally changed the misalignments that still persist between investors, corporations, and stakeholders.

1. 1. The research analysts were financially aligned with the company they were researching rather than with the stakeholders who were relying on the research reports.

1. 2. The auditors were financially aligned with the company they were auditing rather than with the stakeholders who rely on the validity of the financial statements.

1. 3. The credit rating agencies were financially aligned with the investment bank underwriting the securities rather than with the stakeholders who rely on the validity of the ratings.

At the core of the problem is a lack of fiduciary responsibility; those who manufacture, analyze or rate corporate information do so for the client and not the stakeholder relying on the information.  It seems that in order to reestablish trust in the marketplace and to once again reinforce the free-market system, the government must address this real concern.

First, any financial misalignments between those relying on and those creating or supplying financial or corporate information must be eliminated, requiring the mandated divestiture of investment banks’ research departments.

Secondly, it must be ensured that auditors and credit rating agencies are not paid by corporations or investment banks.

Lastly, we must re-establish competition in the market.  Today, there are only four major auditing firms, ten credit rating agencies (with the largest three servicing the majority of the marketplace) and only a handful of reputable firms creating independent research.  Consideration must be paid to the idea of breaking up the four major auditing practices into a dozen or so companies that will foster competition.  Transparent SEC guidelines that enable competent analysts can gain Nationally Recognized Statistical Rating Organization status will also increase competition.  By creating more competition in the marketplace, these service providers will continue to seek out new and innovative processes to help create better quality audits, research, and ratings.

Below are some recent articles that may be of interest.  We will continue to follow the changes in the market for credit ratings, audits and research.  Next week I will be posting a larger analysis of the misalignments between these actors.

http://online.wsj.com/article/NA_WSJ_PUB:SB10001424052748704268004575417811362825370.htm

http://www.nytimes.com/2010/06/01/business/01sorkin.html

http://technorati.com/business/article/credit-ratings-hit-euro-and-greek/

http://www.dailyfinance.com/story/credit/credit-ratings-have-outlived-their-usefulness/19510068/

http://reason.com/blog/2010/08/11/credit-rating-agencies-cant-li

http://www.project-syndicate.org/commentary/bebchuk12/English

YOU CAN READ FULL ARTICLE HERE:

http://www.project-syndicate.org/commentary/rodrik46/English

Have you been to a tee-ball game lately? Did you hear the score? You may be surprised to learn that the score is not kept and there are no league standings, such as what team is in first, second, third or dead last. Despite the idea that there are no standings and no recognized winners or losers, at the end of the season all the teams celebrate with a pizza party and most likely every child will receive the same size reward, regardless of their team and or personal performance. Another example that is similar to, yet different in many respects is the all too often young child in the toy aisle stomping up and down for a toy until the mother or father finally shouts, “Fine, you can have it!”

Although these are only two observations, arguably they underscore a larger movement that is predicated on indulging young children and shielding them from the realization that sometimes you lose and sometimes you cannot get what you want.  It seems that over time, as the nation has become wealthier, this type of pampering has led to generational changes in the United States with the younger generation being taught that it is OK to seek reward when you are not successful and it is OK to buy, even when you do not have the means to afford it. Perhaps it is this type of education that has made us accept the concept of bailing out a company when they should have failed, supporting a homeowner when they borrowed more than should, or paying for unemployment when individuals do not save anything and the list goes on.

It appears as though today, Darwin and his suggestions about nature and survival of the fittest, notions driving the capitalist system have been replaced with more motherly, nurturing approaches. The fundamental problem seems to rest with the parents who guard their children against loss – unfortunately taking away their natural instinct to compete. Capitalism only works when corporations compete fairly with one another with one corporation winning and the other losing. Similar to a zero-sum gain, this capital system cannot sustain itself if we are afraid to facilitate competition amongst our youth. Harsh as this may sound, the youth of the United States need to experience the challenges of life and the joys of success – only than will responsibility regain its position as virtue.

I would contend that children that grew up during the strong economy of the 1990’s and 2000’s tend to be more spoiled and less responsible than those who did not. For example, it seems that the Americans that grew up between 1920 and 1940 became prudent adults and leaders who helped build this great nation. From JFK to Ronald Reagan, Paul Volker to Warren Buffet they all grew up through the Great Depression. These people all share something in common; they seem to believe in the efficiency and competition of the free markets.

On the other hand, the generations that grew up during the Great Moderation, between 1980 and 2000 and who were raised with a more kind nurturing capitalist system have now come into power. People of this generation include George W. Bush, Bill Clinton, Barack Obama, and Tim Geithner. It is no coincidence that these are the individuals that could not let an entity fail. They created backstops for weak companies and disrupted the stronger ones. It is this generation that has attempted to create affordable housing for everyone, bank and auto bailouts, and tee-ball games with no scores.

Fortunately or unfortunately, depending on how you observe the situation, it seems at though the tides will change, as we live through the next ten or so years of dismal growth and high unemployment. As my generation thinks through and painfully solves the problems of our past excesses, perhaps we will learn that we need to keep score with our youth, we need to teach responsibility at a young age because we have learned that it hurts too much and costs us dearly to learn about competition and responsibility when we are entering our productive years.

Luigi D’Onorio DeMeo is a recent graduate of Seton Hall University and a frequent writer at ReinventingTheMarket.com.  Luigi can be reached at — luigidemeo@gmail.com

Author: Richard Lee

FULL STORY

http://www.newjerseynewsroom.com/commentary/to-infinity-and-beyond-the-state-of-media-in-the-21st-century