Keeping a cover on stocks

Brad West of Amba Research talks about how the financial crisis is diminishing research coverage and providing opportunities for independent research houses.
The financial crisis is going to make it harder to find out about companies to invest in. The current cyclical downturn, combined with a long-term negative trend towards research, means one thing: ôWe're going to see the number of companies covered by research departments of brokers drop precipitously over the next six months,ö says Brad West, co-founder and managing director of Amba Research, a provider of investment research support services.

He outlines the following situation: the trend in equity research coverage has been negative since before the dotcom bubble burst in 2000. ôUntil 2007, however, strong cyclical profitability û including, improbably, the cash equities business for several consecutive years û allowed banks the luxury of continuing to support large global research teams and concomitantly big stock coverage lists.ö

According to West, the number of companies under coverage has fallen by 20% to 25% since the turn of the century, but the onset of cyclical losses at the securities firms signals a swifter, sharper reduction than was witnessed after the Nasdaq crash.

ôTake a hypothetical global investment bank û it might cover 1,500 names in good markets, and in a normal cyclical retrenchment it might cut that back to 1,200. Now, you may find it going down to 900 with perhaps 200 coming back on to the coverage list in the next good market environment,ö says West. The area of coverage that is going to be hit the most is small- and mid-cap companies.

This doesn't mean that there is a shrinking demand for research from corporates or money managers. For a small- or mid-cap company, research coverage is a key part of maintaining liquidity in its stock. It also helps the company trade on fundamentals rather than rumours. From an investor's point of view, liquid stocks are highly desirable in the current environment because a position can be unwound more quickly. ôInvestors have been hurt badly in the last couple of months by their inability to unwind their trades,ö says West.

West cites academic research conducted in the US which suggests that the loss of broker coverage on average results in a 110bp drop in a company's share price. Another study holds that the loss of coverage increases the risk of being acquired by 42% and of being delisted by 26%. West thinks that there is little reason to believe that the situation would be any different in Asia.

The upshot of this is that companies may have to start paying out of their own pocket to be covered, says West. ôEffectively they've been doing that indirectly because they've been paying big fees for their secondary offerings, roadshows, etcetera. The money has flowed from the corporate sector into the investment banks and the quid quo pro has been that the bankÆs investment analysts will the cover the stock.ö

Directly paying for research, however, often leads to accusations of lower levels of objectivity. A preferred alternative for a corporate is not to pay a broker directly for coverage, but to use its host stock exchange as an intermediary. The only scheme of this kind in Asia is Singapore Stock Exchange's Research Incentive Programme (RIP), which has secondary board companies getting the exchange to pick a broker to do the coverage. West speculates that the modest price û an annual fee of S$5,000 ($3,200) for three or four research reports a year û is not going to be enough to induce a handful of research analysts who have just lost their jobs to band together in an independent research boutique.

ôWhen you have more regional exchanges starting their own equivalent programmes to SingaporeÆs RIP then that's a clear signal that there is going to be a viable business for independents in Asia,ö says West. ôMore generally, there is no reason why stockbrokers should have a monopoly on covering companies. Research should be written by people with the greatest insights and often that isn't going to be a 27-year-old broker working for a broking firm. You're better off with an industry veteran with 15-years of same-industry experience.ö

West sees opportunities beginning in the next couple of years for independent research companies to produce industry sector reports without stock recommendations. ôIf you're an institutional money manager, and you're picking up a new country or sector, you can get an awful lot of information about companies from brokers and market data vendors, but not much general information on how industries make money and the critical success factors,ö says West.

ôThe current commission structure acts as a strong disincentive for investment bank and brokerage research departments to write that generic piece as their investors buy and sell stocks and not industries as a whole.ö An industry backgrounder with a pro forma set of financial forecasts including break-even and sensitivities analysis can save an in-house analyst at least a week's worth of work.

Of course, that presupposes that this hypothetical fund still has at least one analyst left in house. When the hedge funds were doing well with ever growing assets under management there was a move to bring research in-house with analysts who only published internally.

ôA lot of the analysts who jumped ship in the last three years from the sell-side to the buy-side are going to become luxuries,ö says West. ôIn time, independent research firms may be able to fill the gap albeit with payrolls that will have to be much lighter than what the hedge funds were paying until only recently.ö

In this light, West talks about a business model he has seen in the US and UK: successful boutique research companies being formed by former analysts who team up to research a single sector and then sell their output and insights on a subscription basis to a finite number of professional investors.

ôThereÆs a contrarian opportunity for the research departments of agency brokers to take a deep breath and begin bargain hunting themselves. With analysts being fired en masse, salaries are at decade-low levels and æguaranteed bonusÆ is a phrase heard less often than Lord VoldemortÆs name was mentioned at Hogwarts school assemblies.ö

ôIf you're a securities firm operating anything close to break even, while the global banks are losing money with those big banking overheads, you might find yourself the preferred employer,ö says West. He adds that such is the depth of the current gloom that hiring is going to be very selective for the next six months at least. ôI doubt that the investment analyst guildÆs annual Christmas party is going to be able to fill all the table settings from the 2007 gathering for many years to come,ö says West.
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