Mark Twain noted after a newspaper had prematurely published his obituary that reports of his death had been greatly exaggerated. The same can be said of sell-side research. The Myners review in 2001 and the October 2003 $1.4 billion Global Research Settlement forced on the industry by New York attorney general Eliot Spitzer, seemed to presage a shake-up of existing business models on both sides of the Atlantic. However, on the surface at least very little has changed.
Analysts write, sales teams sell (research is sold, not bought, or at least that is what equity sales people will tell you) and fund managers pay for the service via bundled commissions. Perhaps the financial services industry has taken to heart another of Twain’s famous sayings: “Never put off until tomorrow that which could be done the day after tomorrow.” Institutional inertia is certainly a powerful force, but there has been change.
There are fewer sell-side analysts. According to the National Research Exchange in the US, a body set up to promote independent research, the number of analysts at the Wall Street firms fell by 30% to 995 from 2001 to the end of 2005. Some banks have retreated from research altogether, including Wells Fargo. Nordea handed over maintenance coverage of Nordic stocks to Standard & Poor’s. The large integrated houses have thinned their ranks – sometimes out of choice and at other times because their analysts have joined the in-house research teams of fund managers and hedge funds.
Research has changed. According to Thomson Corp, “sell” recommendations made up just 1% of investment calls in 2000, last year the figure was 9%. A study by Morgan Stanley strategist Henry McVey showed that the 100 stocks in the S&P500 with the highest analyst ranking easily outperformed the 100 stocks with the lowest ranking. Analysts are doing their jobs properly, arguably better than in the past.
Firms are also innovating. Lehman Brothers announced in May a programme to develop a cadre of desk analysts. Rather than be hidebound by the regulatory paraphernalia surrounding published research, these analysts will sit with the firm’s sales traders, talking to clients directly as events unfold.
Probably the biggest contributing factor to inertia has been benign market conditions. The MSCI Europe Index is up close to 80% since the end of March 2003 and volumes have soared by more than 60% in the past 12 months. These are uncommonly good times for European equities businesses. As Warren Buffett said in a different context, only when the tide goes out will we discover who has been swimming naked.
The days of 20 firms populating similar spreadsheets with broadly the same assumptions about earnings and coming up with a ‘me-too’ forecast are nearly at an end. The bull market has probably allowed this sort of product to survive, partly because of the buoyant market for M&A.
“My sense is that research departments would want to focus more resources on bespoke original research, where there is real demand from the buy side. But they still face a lot of pressures to maintain broad coverage of individual stocks,” says Charles Roxburgh, head of McKinsey & Company’s financial institutions practice in London.
Firms that are following a classic, research-driven agency broking approach, such as Cazenove in the UK and Sanford C. Bernstein in the US, are prospering. That is proof that winning in research is not about coverage or volume alone, despite the protestations of the bulge bracket.
Even without a return to the dark days of the bear market, the way firms operate will change. The introduction of FSA PS05/09 on January 1 this year was not a new Big Bang. However, the disclosure by fund managers of how much is being spent on research and how much on execution is significant. At the moment only one-third of fund managers are fully compliant with the regime, but as it works through the system it has the potential to change the landscape.
Pension fund clients will be able to compare what is being spent across their roster of fund managers. That will put pressure on those managers to justify their trading relationships and will force them to apply even greater rigour to how they evaluate research. Twain wrote: “Habit is habit and not to be flung out of the window by any man, but coaxed downstairs a step at a time.” Slowly the business model of research is changing, and for the better.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own.
More Inside Investment