Should you pay for equity research?
As many companies know through painful experience, a lack of research coverage is a serious impediment to attracting new investors. Without it, investors may view a business as unvetted or too difficult to value.
And life for the under-followed hasn’t become any easier in recent years: the financial crisis prompted brokers to further slash research teams, which had already suffered years of decline brought about by regulatory action and declining commissions. ‘It’s getting worse,’ muses Sanford Bragg, CEO and president of Integrity Research Associates, a consultancy that monitors the research industry. ‘Coverage has been cut back as conditions have fallen.’
All of which brings another part of the investment industry into focus: issuer-sponsored equity research. There are hosts of firms out there ready to write regular updates and distribute them to the market for a flat fee. Many companies and consultants talk up the benefits of paying for research, although they warn that not all providers are equal.
The market for issuer-sponsored research received a boost back in 2006 when the SEC’s advisory committee on smaller public companies officially endorsed it. The US regulator should ‘maintain policies that allow company-sponsored research to occur with the full disclosure by the research provider as to the nature of the relationship with the firm being covered,’ noted the committee, adding that independent analyst coverage is ‘critical to the success’ of smaller issuers.
Following that recommendation, a professor at Emory University’s Goizueta Business School decided to investigate the issue, producing a paper called ‘Can companies buy credible analyst research?’. Using a sample of more than 500 US companies and 6,000 reports, Marcus Kirk finds that company-paid research is a ‘viable’ option for firms that lack analyst coverage as the reports ‘have information content’ for investors – in other words, investors traded on them. The reports also help capture liquidity, institutional investment and additional analyst coverage.
Kirk notes that investors appear to be able to distinguish between different types of firms. The reports by high-credibility companies, which Kirk defines as pure research firms where the analysts are not allowed to hold or trade stock, had a greater impact on stock performance, turnover, institutional ownership and sell-side coverage, he reports.
Despite the support of the SEC and Kirk’s study, however, North America has yet to truly embrace research paid for by companies. ‘You’ll always get the initial perception the research is biased, which is very understandable,’ says Brian Tang, president of Vancouver-based Fundamental Research Corp, which provides issuer-sponsored research. ‘If a company is paying for you to cover it, the perception is there’s potential for bias – and that’s true.’
The only way to overcome this is by having proper controls in place, he explains. ‘For example, we require payment from the companies up front, and we don’t accept any other compensation, like stock or options,’ he says. ‘There are some firms that will take options as payment, and we feel that is biased.’
Tang also believes there is a growing acceptance of the model. ‘When we started there were a lot of people saying, This is not going to work, it’s biased,’ he recalls. ‘But what I think they have seen over the years – from our firm in particular – is that we have issued sell ratings, hold ratings and negative recommendations.’
One company that took the plunge is IWG Technologies, a provider of aircraft water solutions that is listed on TSX Venture Exchange. ‘We were advised by our major investors that having an independent analyst is desirable,’ says Bruce MacCoubrey, a director and former president of IWG.
‘We have been using Fundamental Research for several years and are satisfied it provides good, independent coverage. It also offers analyst calls and promotes us at conferences, which is a benefit.’
In recent years, the profile of company-sponsored research has received a boost from deals between stock exchanges and research firms, where bourses either subsidize or recommend products for underfollowed companies.
In one example, Canada’s TSX Group signed a deal with S&P Capital IQ to recommend its paid-for company reports. ‘We have seen this joint initiative lead to a more informed Canadian issuer audience and broader acceptance of the real solution this provides to many of the companies seeking more coverage,’ says Darrell Stone, director of sales at S&P Capital IQ.
Picking the right company is key, says David Collins, CEO and founder of Catalyst Global, a New York-based IR consultancy that primarily supports small and micro-cap companies. ‘Issuer-paid research plays an important role in helping expand awareness and in facilitating understanding and valuation awareness,’ he says. ‘Like everything, however, there are good firms and bad firms. It makes sense when you get it done by good practitioners.’
Collins points out that the distribution capabilities of a firm are just as important as its ability to produce good-quality, conflict-free research. ‘Once a vendor has written a report, then what happens? How do you market it?’ he asks. ‘Some companies are better than others.’
For Bragg, the challenge in North America is getting more investors to rely on the research. ‘We know a number of small-cap investors and they just don’t seem to incorporate issuer-paid research into their research process,’ he says. They get research from other sources, as well as carry out their own in-house analysis, and that ‘seems to be sufficient,’ he adds.
Investors appear to be more open to the model in the UK. In that market, Arbuthnot Securities’ AIM Investor Survey, released in 2010, found that 71 percent of institutional investors see benefits in company-sponsored research, a rise from 68 percent in 2008. The biggest player in the country, Edison Investment Research, has seen its client base expand while traditional sell-side firms have struggled. Between 2007 and 2012, Edison says its coverage increased by 22 percent per year. Today, it retains roughly 400 corporate clients and employs more than 70 analysts across offices in London, Frankfurt, New York and Sydney.
‘Like other publications or newspapers, we put a huge amount of effort into protecting our brand,’ says Fraser Thorne, Edison’s managing director. ‘We will not bend over for one client that is 0.001 percent of our revenue because it wants us to write a particular note. We won’t work with those type of people.’
Some providers of issuer-sponsored research like to draw a parallel with the debt market, where companies pay credit ratings agencies to provide information. This shows that investors are comfortable with research reports paid for by the issuer, they argue.
A report jointly produced by Frost Consulting and Edison last year goes further, arguing that as the traditional market for research continues to decline, there could be a market solution from issuer-sponsored research houses stepping into the breach. Like in the bond market, investors would, of course, be free to take a different view, but the research would provide a ‘base case’ from which to work, say the study authors.
The criticism of credit ratings agencies after the financial crisis, however, makes that comparison problematic. In the run-up to the crisis, the big three agencies put their highest rating on billions of dollars of mortgage securities which were later downgraded to junk status.
‘I think that’s made it a little harder for issuer-paid research to get off the ground [in North America],’ says Bragg.