Responsible Investor

Three simple steps to improve sell-side broker research

Questions must be asked about the depth, transparency and efficacy of today’s broker research.

Investment banks (“sell-side”) spend at least $10bn (€7.6bn) per annum globally on equity research sold to investment clients (“buy-side”). Even after cutbacks in recent years, sell-side equity research remains a well-funded and high-profile activity. It ought therefore to be adding significant value to investors’ understanding of quoted companies. And, since sell-side analysts disseminate their research widely, it should also improve the all-round quality of market information. Yet despite these sizable resources (relative to non-financial areas of research) and powerful advantages, sell-side research has been clearly and consistently shown to:
• Miss most of the major insights or turning points in company analysis
• Err persistently towards Buy recommendations and stances supportive and uncritical of current company management policies
• Follow consensus (and company guidance) forecasts and views, rather than construct independent earnings models and opinions
• Prioritise daily client marketing contact over long term development of fundamental research
• As a consequence, focus on short to medium term valuation formulae at the expense of examining in depth the extra-financial and operating issues which impact the long term sustainability of business models and

company performance. The reason for these failures can be traced to the lack of transparency in commercial relationships between sell-side and buy-side. This lack of transparency arises because:
• Buy-side institutions are loath to make open, direct and significant payments for specified research services
• Instead, they opt for a maze of commercial contracts – across the corporate, new issue and market-making functions as well as commission – which mask their true dealing costs whilst providing broad research cover to defend their decisions
• This reluctance to pay full dealing and research costs has shifted focus and power within investment banks towards corporate fee and proprietary trading income
• Which in turn has exacerbated the conflicts for equity analysts between research for clients and making a contribution to corporate and trading income

The Spitzer settlement in December 2002 aimed to eliminate these conflicts of interest and create a level playing field in which buy-side could access sell-side research on a transparent basis. It has improved the system of research disclosures (to the displeasure of many analysts who complain about “red tape”) but failed to alter the preponderance of Buy recommendations and favourable research on each bank’s own corporate clients.

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