Casting a critical eye over the sell side
Sell-side analysts don't do the job they once did. More to the point, the role they perform now is increasingly being questioned. Where is the profession of equity research going? And how is this likely to affect the job of the IRO?
Once upon a time - about a generation ago - sell-side analysts stood upon a pedestal. They occupied a pivotal position as the primary communication channel between companies and their institutional investors. Until 1975's May Day in the US and London's 1986 Big Bang, trading commissions were fixed at a level that provided brokerages with a more than adequate living. Research-based boutiques, making stock recommendations without fear or favor, flourished. Sadly - but inevitably - deregulation ushered in a world in which commissions from institutional (and retail) clients simply couldn't support in-depth, independent research. Boutiques abruptly disappeared or were absorbed into the up-and-coming breed of investment banks with their multiple revenue streams.
Equity research did not vanish because, in the 1980s, the bulge-bracket investment banks quickly came to realize how valuable it could be in leveraging other lucrative parts of their business, led by underwriting and M&A. Effectively, every Wall Street firm and their international competitors treat equity operations as a loss leader. Indeed, it is standard practice for the investment banking department to pay 50 percent of the cost of running equities. But to accomplish this transformation, the role of the sell-side analyst had to be redefined.
What we did in the 1970s and 1980s, when I was a sell-side and then a buy-side analyst (followed in the 1990s by a spell in investment banking), was not what analysts do now. Originally, the analyst was defined as a commentator, marketing advice to asset managers at institutions, helping them to achieve a better performance - rather than, as now, primarily a conduit between company and shareholder. Even in the unfettered environment that prevailed then, it was still important to be nice to the company you covered in case they turned off the information tap. Following a company that wouldn't talk to you was difficult but not - as would be the case now - impossible.
Guiding lights
The modern equity analyst has become too reliant on companies for information. To some extent, this heavy reliance on management is inevitable. Modern business is too complicated and too fast-moving for any analyst to get his or her forecast right without a lot of help from the company concerned. When analysts were judged by institutions on their ability to get the stock price right, there was a premium on being better informed than your competitors, on sticking your neck out if you were convinced you were right. Instead of consensus estimates there were ranges - sometimes very wide ranges.
Nor were we under pressure to generate business from our corporate 'suppliers' of information. Today the supplier has become the principal customer. The corporate imperative has got to the point at which it, rather than the needs of investors, is driving securities research. A friend who heads investment banking at a large European bank in London recently told me that he had just secured a substantial mandate from a company in a sector that his firm's analysts did not cover. Without the ability to answer the question 'What would the market think if we did this?' he felt he could not service his client properly. Market intelligence and the support to the stock price that securities coverage can provide have become key elements in the 'corporate package'. On the strength of the fee stream he projected for several years ahead, the bank could afford to hire an experienced analyst from elsewhere. Against this background, overcapacity in sell-side research is hardly a surprise.
This is not just an exercise in nostalgia. We can't turn back the clock - nor should we try. Much was wrong with the cozy and protected pre-deregulation environment. But I believe that the present generation of analysts - through no fault of its own - has lost sight of some of the elements that made the job a worthwhile service for investors and a satisfying one for those who did it.
No wonder many experienced analysts have chosen to switch from equity research, with all its constraints, to investment banking sector coverage - on the basis that they were already pursuing corporates part-time so they might as well do it full-time.
Before deregulation, we supplemented the information provided by the company with sources of our own. Typically, we talked to middle managers at competitors, suppliers and customers about business trends. Executives in private companies in the same sector were often prepared to talk about their own and others' performance and were not inhibited by disclosure rules. Another friend who is now an investment banker with a bulge bracket house in London, having been an analyst with the same firm for years, told me a story recently that illustrates this approach. When BAE Systems, the leading British defense contractor, reported results recently, he talked to a long-time contact in the UK government about the company's forecast production schedule of a new aircraft, for which they are the main customer. His source suggested that logistical considerations cast doubt on these estimates. No-one on the sell side had picked up this point.
Back to the future
If the results of a survey on the impact of Regulation FD reflect reality, sell-side analysts are doing more independent checking within their industry, of the kind that they used to do. In April the Association of Investment Management and Research reported that 28 percent of investment professionals were doing more fundamental analysis and a quarter were doing more quantitative analysis - surely a welcome development from the investor's perspective. Analysts who simply go with the crowd have a limited appeal to institutional investors, with their large staffs of buy-side researchers. Professional investors want analysts to challenge their assumptions - and the assumptions of the market. They are viewed as a valuable outside test of the internally held view. But only if they exhibit independence of mind and are capable of looking at their sector from a different perspective, based on insights not available to everyone else.
As the annual All-America Research Team survey conducted by Institutional Investor makes clear in a section called 'What investors really want', the real value of sell-side research lies in analysts' industry knowledge. There are without doubt some excellent analysts with a good understanding of their sector and the ability to explain it succinctly to busy buy-side investors. But there are also those who add little to what they receive from the IRO and senior management, and for whom maintenance of their financial model has become the primary focus. They are conduits rather than commentators. The current system makes it easy for the conduits.
Stock selection and earnings estimates come way down the list in the II survey.
The original stock selection role has been too thoroughly tainted by the other constituencies that the modern equity analyst has to satisfy, headed by the corporate customer of his employer. In actuality, buy-siders take little notice of written stock recommendations, though in conversation an analyst may be prepared to disclose his or her real thoughts. Despite this, the investment banks have successfully promoted the notion to the world at large - and even to some members of the business community - that sell-side research is still a vital part of any institutional buy or sell decision - when the truth is that it is not. Similarly, the effect of Regulation FD has been to emasculate further the analyst's forecasting role.
Sell-side research has moved a long way from its roots. So where does it go from here? The modern analyst has lost two vital roles that are difficult, if not impossible, to regain. Stock selection could once more become a useful service but probably only if you believe that the independent research boutique is capable of rising from the ashes. Professional investors would undoubtedly welcome the reemergence of untainted advice but, given the attitude of institutions and the entrenched position of buy-side research, would they really be prepared to pay for it?
If and when corporate activity recovers, overcapacity - in terms of what institutions want and need to do their job - will continue to exist. Even so, incentives for analysts who are prepared to differentiate themselves from the pack by cultivating a range of industry contacts will increase. Clearly, if this happens, IROs could face some interesting and challenging questions. For those who believe that FD or its equivalent in non-US markets heralds a duller, more routine life for IROs, greater analyst independence could provide an antidote. If the going gets too rough, the beleaguered IRO can legitimately refuse to answer, citing the risk of stepping over the FD line.
Tony Golding is the author of The City: Inside the Great Expectation Machine - Myth and Reality in Institutional Investment and the Stock Market, published by Financial Times Prentice Hall. Further details at www.bedfordpark.demon.co.uk/city