F.A.I.R. - The true value of research

Boston Consulting Group recently conducted a worldwide study into how investors and companies view equity research.

Earlier this year, BCG was commissioned to conduct research into how fund managers perceived the value and benefits of bank-employed research analysts. The firm interviewed many of the major users and providers of investment research around the world and got what could be the fullest picture of the analyst industry ever achieved.

Perhaps most interesting is the fact that that banks themselves are seriously considering the validity of the current industry model. According to Giles Brennand, who runs the firm's financial services practice for Greater China, the banks wanted to know if the current model was sustainable and if not what possible other ways there could be to run their research teams.

What came out of your report as the highest value type of research?

Brennand: A strong message came through in this area. There was a view from most institutional investors that banks have better access to companies and their management teams than investors. Investors place a high value on analysts that have personal access to senior management especially the CFO to find out what the company is thinking about, their views on how the industry in going to evolve and how they are positioning to take advantage of that.

They like to hear the analysts' view on whether the plans they hear from companies are achievable. Investors find that economic analysis is more readily available in the public domain and less interesting to them although smaller institutions with no in-house facilities seem to place more value on this. Another area of value is the database analysis that researchers will do for free for corporates and fund managers.

Do companies make it very difficult for banks to run a decent research team here in Asia as they are not transparent with analysts?

Clearly there's a more sophisticated market inside the US where you even get independent research houses that make their money as publishers. There's significantly less reliance on analyst research in Asia as the available information is poor. This puts a greater emphasis on investors making their own company visits and receiving 'informed gossip' or word of mouth advice from the market.

If an analyst puts out a sell call on a company in Asia the bank won't get any further business from the corporate, which is not the case any more in the US. Business relations are still very personal here. Companies feel that negative comments are criticizing them as individuals. It's an issue of trust, which is what drives this lack of transparency and means that the analysts have to make more guesses and assumptions when coming to conclusions.

If they have less evidence to support their conclusions than they would in more open markets it is easier for a company to say that the sell recommendation is not justified. This makes it more difficult to see which are the really high performing companies.

What was the impetus for your banking clients to consider change? Is it the lawsuits, is it Spitzer or is it just a fundamental realization that they are not making enough money on research?

The lawsuits have been decisive. Previously there had been a bit of self-flagellation for their excesses, which were very clear in technology research, but there had not yet been a real change in attitude. There are also likely to be some changes driven more by economics. Research is very expensive, especially with a lot of relatively small stocks to cover and different dynamics in the various markets. Not everyone can afford to do global research across all industries and I believe one change necessary for some smaller players is greater specialization.

There are probably opportunities for consolidation in Asia. For example, most banks need to be able to say something about Thai stocks but don't need to have their own research teams. If four or five research houses did the work it could be shared across the 20 major banks. That model has attractions from an economic point of view.

Do you see any of the banks going for real structural change?

Wholesale change is not inevitable. Banks remain dependant on the research analysts to help sell investment banking deals and the increase in in-house research on the buy side looks set to continue, but the report certainly detects a shift in the balance of power.

The ruling that Merrill Lynch has to pay a $100 million fine for its part in fueling the internet bubble has sent a strong signal that what was deemed acceptable investment banking behaviour even six months ago is now considered criminal. I expect the ruling will drive a change in behaviour of senior management and ensure directors of businesses take their responsibilities more seriously.

Now the rules have been defined it becomes a more serious issue to defy them. This is a hot topic at the moment although the industry would really like it to go away and escape the intense scrutiny it finds itself under.

It is not leaping into significant structural changes but I don't think a better business model has been worked out yet. The regulators saying "you must stop doing this and that" is not very helpful unless they come up with an alternative model. The banks still want to have researchers close to investment bankers as they genuinely believe that creates value for customers and for themselves. Researchers provide investment bankers with ideas and the bankers provide them access to corporates. Making them entirely separate does destroy value.

What models do you see emerging?

I see separate research groups emerging. There is the group which supports the brokerage business, the group supporting the investment banking business trying to identify potential deals and then a third group on the buy side in fund management houses.

I think saying that there are some research houses that are dedicated to brokerage and others to investment banking could make some sense. You can make the distinction: this is an analyst that advises brokers on the trading of securities to buy and sell and this is an analyst that advises us on what companies to buy and sell.

In your report did you find out what the companies think about the research done on them, over which they have little control? Also about how they are then forced to manage their businesses according to what those analysts forecast their earnings to be?

The point from companies was that they do get upset when they get negative research, which does not encourage positive sentiment in the market place. They admit that this will influence their choice of bankers going forward. There is a structural problem in the model รป the solution is not to say that they won't talk to analysts but rather to talk to more people more often. It will become less about giving a private briefing to analysts; more about doing a public web broadcast that retail investors can access as well.

In that sense there seemed to be an intention from corporates to be more transparent. There is still a problem with earnings forecasts, which are an important issue and both a CEO and CFO can spend a lot of time worrying about that and managing the business to that end.

Analysts seem to get into trouble in when they are making future assumptions. Should they just focus on the current state of the company and not make any recommendations?

Investors want recommendations even if they know they are influenced. It is the recommendations that people pay for. Researchers could be forced to make stronger calls. I quite like the idea of saying that a researcher has to list all the stocks that he is following and rank them in order so that he can't say all the stocks are the best ones ever. If one is best, that implies the others must be less good but analysts seem to get away with giving the impression that all buys are equally good.

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