WALL STREET RESEARCH, July 2002

An Independent and Pure Research Shop
by Ben Mattlin

In April 2002, John M. Dutton, president and director of research at the El Dorado Hills, California-based J.M. Dutton & Associates, was wooing chief executive officers of American Stock Exchange-listed companies at their semi-annual convention. The CEOs weren't used to receiving attention from research directors. Wall Street, after all, tends to favor the larger and better known companies of the New York Stock Exchange and Nasdaq Market, which are seen as more likely to generate rapid sales commissions and lucrative investment-banking deals. But, Dutton told the assembled CEOs, all that was about to change. "They should get to know us, I said, because they might want to do business with us," he later recounts.

Dutton, who has worked on both the buy and sell sides on and off Wall Street since 1966, launched Dutton & Associates last September, before the terrorist attacks, to seek out under-covered stocks wherever they might be hiding. With 14 analysts spread across the country tracking 30 small- to micro-capitalization companies ranging from $10 million to $500 million, the firm has no investment-banking or securities-trading operations. It is a research shop, not a brokerage.

Headquartered a half-hour's drive east of Sacramento, Dutton & Assoc. stresses nothing but pure, old-fashioned independent research unadulterated by corporate-finance and trading pressures. "That's the way I was taught to do it," says the distinguished, thoughtful Dutton, a Brown University graduate with an M.B.A. from the University of Pennsylvania's Wharton School.

Indeed, in an era of increasing scrutiny over sell-side analysts for alleged conflicts of interest, Dutton's back-to-basics philosophy sounds refreshingly honorable and extraordinarily well timed. What's more, Dutton's team of seasoned analysts comes armed with decades of professional experience, chartered-financial-analyst certifications, and active memberships in the Association for Investment Management and Research, an independent organization dedicated to maintaining a high standard of business ethics. The firm may not be the only dedicated-research outfit, but it has the most mature analyst roster, with an average age that's roughly double that of many Wall Street hotshots today -- another point of pride. "There's real value in maturity," observes Dutton, 59. "Young people assume when the market's hot it's going to stay that way, but I've been around long enough to see every cycle come to an end." Specialty-foods and gaming analyst Gerald F. LaKarnafeaux, himself 65 years old, adds: "We've all been around the block a few times. We are not going to be misled very easily."

But the other point about maturity has to do with a sense of responsibility and ethics. When the Securities and Exchange Commission recently proposed new regulations for analyst conduct --such as barring them from owning shares of companies they cover -- Dutton's squad was already a step ahead. They've never been allowed to hold the stocks they follow.

Of course, whatever their degree of moral integrity, the firm's got to make money somehow. This is another way Dutton & Assoc. differentiates itself from its three or four pure-research competitors: its revenue model. "Our revenue model is the best for avoiding conflicts of interest," asserts Richard Hefter, Los Angeles-based vice president of sales and marketing.

Regional investment banks and brokers with insufficient or inadequate research capabilities outsource to Dutton & Assoc. But other, often-misunderstood revenue sources are under-followed companies willing to pay for coverage. Hefter and Dutton actively solicit such business, which is largely why Dutton attended that April AMEX company CEOs meeting. From the outset, it's made clear to corporate candidates that they are not buying recommendations; they're buying coverage. They pay for one year in advance, and let the chips fall where they may. Dutton compares it to credit ratings from Moody's Investors Service and the like, which are based on independent, objective research. "We're not an investor-relations firm," Hefter stresses. "Companies know that when they hire us, and they understand that our only value to them lies in our credibility."

Do all companies without coverage deserve coverage? Perhaps there's a good reason they've been overlooked. But Dutton & Assoc.'s Robert Davis, who studies coverage statistics, asserts that stock coverage is directly proportional to stock size. All other things being equal, the smaller the company the less likely it is to draw an analyst's attention. And the problem is growing worse. Today, only 41% of companies with market caps between $50 million and $75 million receive sell-side earnings forecasts, for instance, whereas last August more than half the companies in that bracket did.

Dutton estimates some 5,000 small-cap companies in the United States are going without adequate research coverage. "They trade more cheaply than their listed counterparts even when they have better margins, better growth rates, and better management," he observes. In truth, the drop in available research on small-cap stocks is even more surprising when you consider the relative performance of Standard & Poor's Small Cap 600 to its big-brother benchmark, the S&P 500. Last year, the smaller companies advanced 6.5% while the broad index plunged nearly 12%.

Yet Dutton's firm isn't open to providing research on all comers. They must be "well run and high quality" to pass his screens. Over-the-counter Bulletin Board stocks can and often do pass, but Dutton draws the line at penny stocks listed on the "pink sheets."

An accepted company is then assigned to an analyst, who earns a fee up front to track the stock for one year, in a kind of freelance arrangement. Strictly speaking, the analysts are independent contractors. Their compensation is based on the number of companies they follow (capped at eight per year, to avoid burnout), the number of update notes they write beyond the initial and quarterly reports and the accuracy of their forecasts. Because all fees are paid up front, analysts are free to conduct their research and formulate their opinions without concern about ruffling management's feathers. They're not even afraid to issue sell ratings when appropriate. "My opinions are based on my research, not on how we can get a buck out of trading the stock or doing a deal with the company," insists analyst Richard W. West, who monitors financing and technology companies from a base in New York. "We're not pushed to come out with a certain rating."

In another surprising aspect of the revenue model, research reports are distributed as widely as possible -- simultaneously to Multex.com, FirstCall.com, the company's own free website (www.jmdutton.com), and an ever-growing mailing list. "We don't charge for our research," says Hefter, who defines an important part of his job as "making sure the product has the widest possible readership."

That's true to the mission Dutton set out on . . . "The more sunlight that shines on every step of the process, the better for everybody," Dutton holds. An avid airplane pilot and sailor in his off-hours, he knows a lot about sunlight. And about independence.

If you can talk about loyalty in a company that's not even a year old, Dutton's analysts appear loyal to the man and the mission. Sherry Grisewood, an analyst based in New Jersey who covers "healthcare-enabling technologies" and doubles as assistant director of research, has worked with him at two different firms -- a distinction shared by many of her colleagues. She boasts 25 years on the sell side, monitoring a variety of special situations and small-cap stocks both independently and for such firms as E.F. Hutton Co. (now part of Lehman Brothers) and Donaldson, Lufkin & Jenrette Securities Corp. (now part of Credit Suisse First Boston). Grisewood is currently focusing on new technologies that enable less invasive therapeutic solutions.

Her Seattle-based colleague Les Childress leverages as many years' experience in energy and special-situations research. Turnaround opportunities and the misunderstood are among his favorite finds, but he also keeps sights on community banks and, increasingly, Canadian stocks. Famously skeptical of management, he puts more faith in strategic execution and a sound balance sheet.

Such no-nonsense values pervade the analysts' reports, which are surprisingly well written and to-the-point. Though largely aimed at individual investors, they are fashioned with an eye toward "institutional quality." Dutton himself wields an editor's red pencil over every word. "If you can't communicate your views clearly," he muses, "you might as well be a portfolio manager!"

The research director is actively recruiting to expand the department into new sectors, and he anticipates a coverage universe of 75 companies by year-end, triple the current size. A London office is also underway, followed shortly by one in Asia. The heady excitement is palpable. Observes vice president Hefter, "You can feel the analysts' delight at being able to do research without strings attached."