Last week, I posted on the future of the IPO market in response to an online interview with Marc Andreessen. I wanted to follow that up with some broader comments about the state of equity research analysis.
In my post, I pointed out that one of the big sticking points for traditional, investment bank-run IPO processes is that the banks usually provide research analysts to follow the company after the IPO. Google can try to propose its own IPO mechanics, but few other companies have that ability. They need the research coverage and cannot rely on their own efforts to keep their story in front of investors.
The problem with this is that the traditional equity research model is essentially broken, and I would argue, is overdue for some web-based disruption.
First the basics, equity research analysts work for brokers and investment banks. They provide regular written analysis of the companies they cover. The basic premise is that institutional investors, the people who manage our retirement assets, often cover hundreds of companies across a dozen industry sub-sectors. They have to focus on portfolio management and other tasks, so they cannot do in-depth research on every stock in their universe. By contrast, equity analysts cover 20 or 30 stocks. They get paid to do in-depth analysis. They generally speak with management teams regularly, and develop other data sources on the companies and industries they cover. These analysts provide the in-depth coverage that their clients, the institutional investors, cannot do. The investors pay for this research by paying commissions for share trading with the brokers who employ those analysts.
Once upon a time, analysts were ‘rock stars’, among the most highly paid investment bank personnel. They achieved this status because beyond the traditional analysis work they did, they also helped the banks promote IPOs. Banks would pitch their analysts’ status as a reason for having that bank participate in a company’s IPO. Analysts could thus generate two streams of income for the banks – trading brokerage comissions and investment banking revenue.
Over the past decade this model has become entirely unglued.
First, the analysts’ role in IPOs was abused in the dot.com Internet bubble of the 1990’s. The abuses of a small number of analysts, let to a regulatory overhaul of the whole industry. Analysts are now largely prevented from participating in the selection of IPO underwriters. It is still a factor in company decisions, but the banks have had to drastically scale back their analysts’ involvement in pitching business. Investment banks can still share IPO revenue with their research departments, but the banks can no longer directly tie their analysts’ compensation to those revenues. It is murky and confusing, and deliberately ineffeicient, but the final impact is to greatly reduce analyst compensation.
The second problem is that brokerage revenues have come down sharply at the same time. It is much, much easier to trade shares now, as the process has gotten computerized. Brokerage commissions were once something like ten cents a share, but are now a penny or two, heading towards zero. So while the analysts still have sway in guiding investors’ trading decisions, the amount of dollars available to compensate them has shrunk.
The end result of all this is that analysts generate far less revenue than they used to, and get paid far less. Predictably, this has led to lower quality analysis. (See next post for more on this.)
Compounding all this is that the brokers who employ analysts do not fully grasp what the problem is or how to solve it. Maintaining a research department is expensive, as it requires a large compliance staff to meet all the new regulatory demands. Many of the old analysts are still employed, which also keeps the costs up. The old industry model no longer works, but no one is quite clear what the new model should like. Equity research is now a marketing function with the cost structure of a profit center, without the ability to actually generate revenue directly.
I think it is time to go back to basic principles. At heart, equity research is content. It is the height of folly, to think that this is going to be the one form of content that does not get entirely disrupted by the Internet and ‘software eating the world’. Yet most of the institutions involved still treat research the same way they have always have. Reports are still published as PDF’d documents, as if someone is going to print them all out. Research reports are generally all hived off behind paywalls. Social media usage is almost zero, and let’s not even discuss Twitter. For readers of this site coming from the Valley and Internet world, you would be shocked, or slightly embarrassed, by the state of affairs.
Over the past ten years or so, many companies have sought to offer other models. The last Bubble saw sites like TheStreet.com pop up. More recently, sites like Quantopian have popped up. TheStreet.com has become a mass media site focused on general consumer readers. Quantopian, and some of the other sites, have a more professional user in mind, but only focus on one part of the problem. There is still considerable opportunity to improve equity research. What that looks like, will be the subject of a future post.