Back to the drawing board: changes in the old sell-side model
People have been proclaiming the death of the sell side for years, but it is hard to deny that it now faces a more serious challenge than ever before. A catastrophic recession, an increase in electronic trading, Regulation FD and, of course, Eliot Spitzer have all had a role to play in helping to remould the old investment banking model.
Tabb Group data for the US reveals that the commissions paid to the sell side by the buy side have shrunk from 3.89 cents a share in 2004 to 1.89 cents a share in 2008. The upshot of the lower commissions is that trading volume wins the day: large firms with high volumes are still moneymakers for the sell side and so are retaining their coverage.
‘I estimate that the sell side has to generate 12 times more trading volume today to make the commission it was getting in 2000,’ comments Dan Dykens, CEO of Meet the Street, a facility that match-makes investors with public companies that fit their investment criteria. ‘Smaller caps with less volume do not generate sufficient revenues, which is why companies like Google and Microsoft can still be covered by 35 analysts each while everyone else loses out.’
The squeeze has also been exacerbated by the collapse in valuations, which has led to a proliferation of small and micro-cap firms. For the majority of these less fortunate companies, the sparseness of analyst coverage signals a substantial IR challenge.
‘We had one Biotech firm that had 10 analysts covering it and now it’s down to two – that’s significant, and it’s happening on a widespread basis,’ comments Rob Whetstone, managing director of IR firm PondelWilkinson.
Despite the challenges, Whetstone says firms should not give up hope of obtaining new coverage. ‘There are definitely analysts looking for new directions and if you have a good idea they may well begin coverage. Some firms remain very popular, especially those from ‘hot’ sectors,’ he points out.
In the absence of coverage, however, IROs are increasingly reaching out directly to the buy side. David Mason, executive vice president of corporate development at Canadian IR consultancy Equicom, notes that low valuations present opportunities for companies to market their cut-price stock to investors that want to make big returns.
‘In a market that arguably has no direction, there are opportunities for those on the buy side to make good returns on small caps where there is inefficiency in the market,’ Mason explains.
IR practitioners have also reported spending more time helping the buy side to formulate its own in-house research, as well as getting more requests for one-on-one meetings. ‘You can see the buy side is becoming a lot more active,’ comments Bernard Compagnon, a partner at communications consultants Kreab Gavin Anderson. ‘Companies are getting more calls from buy-side investors to come to see them directly. They want to go in-depth, and do it without witnesses.’
This trend may be putting a real strain on IR but it is a development welcomed by those who see an increasing disconnect between different parties’ informational needs. ‘There is a huge discrepancy between the timeframe of the buy side and that of the sell side,’ Compagnon states. ‘Increasingly, institutional sales need greater news flow in order to trade, so the analyst needs stories that will lead to immediate trading activity.’
He adds that, by contrast, the buy side is looking for long-term indicators of health: ‘In its haste to create immediate reasons to buy or sell, the sell side will often go out on a limb. It will take a rumor or hypothesis and turn it into a report based on thin foundations.’
So is all this making sell-side research less desirable in the first place? As banks consolidate their research departments, questions are being asked about the quality of research available. Recent data released by State Street Global Markets show that fund managers in Europe are increasingly indifferent to sell-side recommendations, paying less attention to them now than they have done for more than a decade.
Despite these reservations about the performance of the sell side, however, many firms are still fixated with upping their coverage.
‘Many companies still see increasing analyst coverage as a key objective of their IR program, and if analyst coverage was important a year ago it should be of equal importance now,’ Mason states. ‘That doesn’t mean you should be spending more or less time on the road but you do need to spend more time on developing your IR program to make sure analysts can get more visibility into the business.’
The decreasing significance of the sell side need not signal the end of research per se, however. As the research gap widens, increasing numbers of analysts are setting up their own businesses to offer independent equity research outside the confines of the investment banking model.
‘I think we are going to see the rise of the boutique firm again, specializing in a few industries and doing a good job of it,’ comments Don Duffy, president at financial communications consultancy ICR. The rise in new research firms is undoubtedly good news for IROs, though it will require expertise to target the new firms.
As well as a rise in independent houses, former analysts are launching new initiatives to connect IROs with investors, such as Meet the Street. Dykens hopes his model will render the equity researchers superfluous. ‘For the vast majority of the public companies that have little to no coverage, there isn’t much choice out there,’ he says.
The changing sell side has also presented challenges for agencies and their clients as the supply of free roadshows delivered by corporate access teams dries up for all but the largest companies.
‘I think the number of roadshows coordinated by the sell side has come down,’ says Mason. ‘In my view this creates an opportunity for agencies to coordinate those roadshows. These are great for agencies because you are connecting to the client and the investor audience and feeding back to the client.’
The opportunity for agencies has also generated some headaches. ‘It’s a shock for some companies that aren’t used to paying for these services,’ Compagnon observes. ‘It’s taking some of them a while to figure out that we won’t do it for free.’
As budgets tighten, companies are increasingly scrutinizing the work done by their agency. Getting the best out of your agency involves being open and honest as well as realistic, and most agencies will help their clients to draw up a set of attainable objectives from the outset.
‘If they feel they are undervalued by the market, that is not something we can help them with – we have to be realistic,’ Duffy explains. ‘So we look at their skills and come up with something achievable. We then develop the tactics to achieve that objective, whether it be targeting investors, increases in financial media coverage or analyst coverage, or increasing levels of institutional ownership.’
The old model may be under review but what the doom-mongers often fail to recognize is the staggering ability of the sell side to reinvent itself in times of crisis. IR practitioners should be similarly entrepreneurial. As the marketplace undergoes various permutations, IROs have the potential to be beneficiaries of market developments.
‘The ongoing theme is how agencies are demonstrating their value to companies,’ concludes Duffy. ‘We’ve seen a lot of firms asking tough questions of their agencies and, as budgets tighten, we expect that to continue.’