I have been writing lately about the state of equity research. In the comments a few people mentioned alternatives that already exist, and I mentioned a couple in my post. I should highlight Estimize as one of the more interesting ones that escaped my earlier list.
Anyone wanting to start a company that tackles this problem will have to confront the fact that the role of equity research is very unclear, and hence its value. In my first note on this subject, I noted that for the investment banks and brokers, equity research is now a marketing function. It helps to show the value of the firms’ underwriting and trading platforms. But that is just one perspective, it leads to a bigger question. Does research actually influence clients’ decisions about those other things?
Remember that there are two ways for financial firms to monetize research. It can drive trading revenue as institutional investors trade on the stocks that the analysts cover. It can also drive companies considering IPOs or other financial transactions to choose one bank over another. This second function is a complicated topic in its own right. I will save it for another day, one of my IPO posts, or my over-the-horizon IPO book. For this post, let’s just focus on the ability of research to drive trading revenues.
I do not have the exact stats, but equity trading is a multi-billion dollar industry. It is much smaller than it used to be, and shrinking more as commissions and trading spreads plummet, but it is still a big business. The world’s institutional investors still use the large and small brokers to execute trades. Technology is at the point where most funds could probably eliminate the trading commissions they pay, but for some reason they still pay something to their brokers. Some of this value comes from the trading platform itself, the brokers, especially the big ones, have some clear advantages in providing liquidity. But if you ask most investors (and a growing number of traders) there is a clear sense that trading is increasingly a commodity.
So there must be something else, and part of that something else is likely research. Good analysts can provide value. I would lump the areas they provide value into five categories:
* In-depth knowledge of companies and management. Fund managers often cover hundreds or thousands of stocks. The research analysts cover a few dozen. They have the time to pick up deeper knowledge, and help keep the investors up to date when needed.
* Access to company management. It is hard for companies to get their message out, especially smaller companies. Management teams only have so much time to spend meeting investors. By dedicating a large portion of that time on speaking to research analysts, they can leverage the voice those analysts have.
* New ideas. This one is a bit tentative, but analysts can and do come up with good ideas.
* Legwork. Good research requires a lot of work, chasing down contacts, organizing schedules, building financial models, etc. Investors could do all of this themselves, but having the analysts do it saves time.
* Providers of consensus estimates. Every quarter, all companies’ results are compared to published estimates, and those comparisons drive big swings in stock prices. Those consensus estimates are still collated entirely from the public research analysts. (Estimize is seeking to change this.) Having a vote in this process is hugely influential.
* A public face. This is probably the most important piece. Analysts are public figures. They get interviewed on TV and in the press. Their sales force makes sure their voice gets head by thousands of investors. This is an important position, but also a tricky one as all the constituencies involved seek to influence it.
What it all boils down to is that analysts have a public-facing role and have the time to do in-depth research. Any business model seeking to alter the current model will need to provide a public platform with wide outreach and a way to collate useful data back to interested parties. Fortunately, these like like problems built for the Internet to solve.