The importance of research in the investment making decision process
A share price is a corporate barometer; it should reflect the underlying trading health of the company and its position within the competitive landscape. To do this, all equity investors need access to quality research to help ascertain whether a particular stock is right for their portfolio. The volatility of share prices that we have all experienced over the past 24 months highlights the ever increasing need for effective communication with the markets. Investors like predictability, visibility of future earnings and steady share price movements. Directors must remember that it is the shareholder, who ‘owns’ the company and he needs access to all relevant information to take a reasoned view on the current valuation of the group. This boils down to access to equity research.
The economics of Investment Banks and the Broker funded model
As can be seen in the diagram above, an Investment Bank has several business lines. Post ‘Big Bang’ in 1986, the London market was changed out of recognition. Traditional ‘independent’ brokers are now mostly part of larger Investment Banks. Electronic trading and deregulation have caused equity commissions in the US to decline from $0.75 per share in 1975 to 1c. The trend is the same in the UK where the large US players are dominant in trading volumes. As profits from trading fell, Investment Banks cut the budgets of their research departments (by 35% between 2001 and 2005); as a result, the number of analysts working for Investment Banks declined and more seasoned analysts have often been replaced by cheaper, younger talent.
Who is the broker’s client?
Banks and brokers will publish investment research if they can make an economic return on it. They monetise their research effort via commissions on transactions, trading, market making and corporate finance. As a result, although a broking analyst primarily serves the sales team, he can be taken ‘over the wall’ to assist corporate finance on occasion. While the rules have been tightened around this, it remains a major conflict in the investor’s eye. The significant fees that can be earned from corporate finance mandates often dwarf those that can be earned from traditional broking, especially in the small cap arena. As a result, the buy side has invested in its own analysts often providing broad sector coverage. Yet they are still hungry for ideas and in depth stock analysis - something they rarely have the time to perform themselves.
The need for a new research model?
Institutional investors need quality research. Quality research should be balanced, insightful, timely, readable and financially rigorous, and it should also be made freely available to all potential investors. Research firms must have strong credentials with other advisors such as bankers, brokers and PR firms. They need to be in control of their own distribution and be able to demonstrate that the research is being Continued overleaf distributed in accordance with regulatory requirements both locally and internationally.
There exists an information asymmetry - investors want it/need it but brokers are no longer able to fund it, nor are institutions used to having to actually pay for it. By using one of the new breed of research providers, such as Edison, companies can ensure they take a lead role in communicating with investors to ensure the whole market has access to quality investment research. Through the production of research that is of the highest quality, widely distributed and subsequently well read, a company is able to reach out to the whole market and meet genuinely interested investors. This allows management to build valuable long term relationships. Commissioned research enables any company’s Board to retain control of the information in the market and its distribution.
Corporate commissioned research is set to become a de facto requirement for listed companies in the same way that one may retain a PR firm or a corporate broker. It is the way of the future for communicating with the broader market in the modern environment of multi media. For Edison it is based on the old fashioned principle of delivering a good, value added service at a sensible price. In today’s volatile market, companies should be self sufficient with regard to the delivery of analysis to ensure a fair value for their equity.
Fraser Thorne is Managing Director of Edison Investment Research, Europe’s leading independent investment research company. Edison writes on more than 250 companies across every sector, and its research is read by every major institutional investor in the UK, as well as by the private client broker and international investor communities. Edison is authorised and regulated by the Financial Services Authority.