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 andcompany 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.
The launch of the Enhanced Analytics Initiative (EAI) in 2004 sought to encourage research beyond the limits of short term financials. Its radical idea of linking income (5% of participating institutions’ annual commission total) to bench-marked quality research in SRI issues struggled against the domination of fully bundled corporate, trading and commission packages. Yet it had started to attract significant SRI-focused research efforts from a dozen bulge bracket and other leading banks by 2007. Ironically, the banking crisis of 2008 (itself a classic example of a fundamental event which SRI-style research would have been better placed to identify) has led to retrenchment by investment banks from research in general and from SRI research in particular. A similar fate awaits post-Spitzer initiatives in “unbundled” research from non (or less) conflicted boutique broker-banks. The logic of quality research standing apart from corporate client and proprietary trading pressures is flawless. It has to be the logical way to raise equity research quality and independence. Yet few firms offering earmarked, unbundled research services have succeeded beyond the specialist boutique level.
The weight of existing relationships between buy-side and sell-side militates against such initiatives. It is arguable that only legally enforced separation of corporate, trading and broking functions (i.e. break-up ofintegrated investment banks) could achieve full transparency and independence in the supply of equity research.
In the absence of such radical reform, the following three manageable steps would improve research quality:
• Full disclosure by sell-side and buy-side of all commission contracts
• Compulsory publication by sell-side of their recommendation balance (Buy/Hold/Sell) for (a) all covered stocks, and (b) corporate client stocks
• Compulsory reporting by sell-side of all incidents in which company management denies access to non-favourable analysts (“analyst freeze-out”)
These are modest steps and simple to implement. They would not eradicate the failings of sell-side research at a stroke but they would at least make it harder for corporates and investment banks to conspire in neutering the analytical edge of equity research. And they might encourage buy-side to see their long term advantages in paying directly for less conflicted and more deeply questioning sell-side research.Link to full discussion paper on sell-side research
Jamie Stevenson, Michael Mainelli and Raj Thamotheram are all members of the Network for Sustainable Financial Markets Link to NSFM website