Equity analysts: The omission problem in Latin America
As research departments become revenue earners, their coverage universe will become a crucial part of the business strategy.
It is often thought that the evaluation of equity analyst teams at investment banks is transparent. Target prices and investment recommendations can be tracked over time. The leading industry awards from Institutional Investor use a survey approach, but the evaluations made by its respondents will certainly be a function of analysts’ accuracy.
However, what is being judged here is the coverage of what they cover. Not what they don’t.
And absence in terms of coverage can be a big problem for investors who are seeking new investment ideas. And although no institutional investor just passively uses their counterparty banks’ research departments to create a universe of investible stocks, there is an issue for both investors and the banks if the coverage of names is not as complete as it could be.
Take Banco Supervielle. Of the traditional Wall Street and European banks, only three cover the Argentine-based bank that IPO’d in New York in May 2016. And two of those, Bank of America Merrill Lynch and Morgan Stanley, led the transaction.
That leaves just UBS as the bank that decided (without underwriting bias) it was worth adding to their portfolio of Latin American financial stocks.
And what a story it has been (and one Euromoney celebrated in July this year when it awarded it the best bank in Argentina). UBS’s team looked at it, saw it was a small bank but one with tremendous opportunity. This year, the bank’s share price has risen by 79.8% (in US dollars – it listed on the NYSE).
So the banks that must now be considering adding it to their coverage list will be very late to the party. Ironically, their continued reticence may be a factor in Supervielle’s persisting valuation discount to its Argentine peers and means that the potential for outperformance remains for the analysts who do cover the bank.
While I could not find any specific research into the relationship between a stock’s coverage universe and its valuation discount/premium to its peer group, surely it must be a function: the fewer the investors being exposed to a stock, the lower the demand. It is a kind of reverse-index effect.
I didn’t get much response when asking the other banks why they do not cover Supervielle. It has probably become a bit of an embarrassing omission. Maybe they thought the bank was too small – not a liquid enough stock?
More likely it was a capacity issue. Increasing funding for equity research isn’t exactly a priority for investment banks at the moment. The impact of the Market in Financial Instruments Directive (Mifid) II is going to be considerable: investors will need to make explicit payments for research in order to be able to show they are not being induced to trade with ‘free’ research.
And that move to unbundling research from trading services will cause an existential question for research teams: can they stand on their own in revenue-generation terms?
Some will. Some will struggle.
Will it be an opportunity for the regional investment banks to brand themselves as centres of comprehensive coverage? Will the global model crack in places – split into banks with coverage of certain industries but unable to compete everywhere?
Here I will declare an interest. In recent years, fewer of the large investment banks have been sharing their research on Latin American and global financial institutions with me. Some banks explain their decision not to send me these reports by quoting regulations.
(I forget which specifically, but I remember looking these up at the time and being unconvinced by their strict interpretation – a view strengthened by the fact that other banks’ research teams, covered by the same regulations, continued to send their reports my way.)
Other banks were more honest. “We don’t share research about competitors,” has been a reason given to me by some. Whether that is to prevent embarrassment to their own institution or the other banks they cover has not been made explicit.
I asked a senior manager in the research department at an investment bank that currently has a policy not to send any single-stock research to the media whether Mifid is going to change this approach? Will research teams need to compete for exposure – to build profile and compete to win business? Will they, in short, start sending me research again?
The response was honest – they still don’t know: “Mifid II is definitely a game changer,” said the manager. “I don’t foresee that impacting our media policy on equity research, but we are definitely in unchartered waters here, so it will be interesting to see how it all plays out, that’s for sure.”
I’ll take that as a maybe.
But the broader question – more important than my ability to steal story ideas from equity analysts – is what this will mean for research strategy? What will be the right size for their research teams and their stock coverage portfolio?
These will be difficult strategic choices, especially when considering that the names a bank doesn’t cover are just as important for its clients as the stocks that it does.