As former analysts, we like to keep abreast of the Equity Research business. Unfortunately, the industry is not doing so well. As we detailed a few years ago, the industry faces a basic problem with too many analysts chasing a dwindling pool of revenue.
Equity research has been burdened with an indirect revenue model for decades. Clients, (i.e. professional investors aka the Buy Side) pay for research through commissions paid to a brokerage’s trading desk. This has meant analysts have to fight with two other parties for those commissions – the sales team and the traders. In recent years, trading commissions have come under immense pressure. There is no reason to pay a commission on a stock trade, it should be a business that is counted among the most vulnerable to the Internet. To make matters worse, customers (i.e. the funds) are themselves facing a shrinking revenue pool for roughly the same reasons.
Now all of this may be about to change. The European Union recently put in place a new set of financial regulations, eloquently named MiFID II. Among many other things, these regulations force the unbundling of trading commissions and research. Funds in Europe have to make explicit payments for each separately. We will not get into the thinking behind this, the point is that this is now the law of the land in Europe. Many of the largest US Funds, who have sizable European businesses, are in varying stages of bringing all their operations in line with these rules, not just in Europe, but in the US as well. And while it seems unlikely that the US government will enact similar rules, we will likely still see many other US funds start moving along these lines as well.
It turns out that when pushed into this position, most investors will not pay much for equity research. (The Economist has done a good job of outlining this.) Analysts we have spoken to now lament that their European clients have disappeared. A tried and true ritual for analysts is the annual week-long European death march – client meetings in seven or eight cities over five days. That ritual is now gone for most. If more US investors move down this path it will put a further, massive strain on the business.
That all being said, there is a fundamental disconnect taking place here. Despite all the problems we mentioned above, global equity commissions were something like $40 billion last year. They cannot be paying all of this solely because of the value of brokers’ trading platforms (a number that has to be pretty close to $0) or for the great ball game tickets they get from their sales people. Investors will pay for good research.
There are really two phenomenon at work here. First, it seems that there is some odd Behavioral Economics going on. Research used to be perceived as ‘free’, so having to pay for it know feels very painful, despite the fact that investors were paying for it before without being entirely conscious of the fact. Never underestimate the dis-logic of human nature.
Secondly, investors only want to pay for ‘valuable’ research, and it is very hard to discern where that comes from. Without a clear pricing mechanism it was possible for analysts to churn out research in quantity, with quality taking second place. In fact, it is probably the profitable model given industry conditions. Making a lot of noise about a stock drives name recognition, so that at the end of the quarter when investors are trying to allocate commission dollars they remember the loudest analysts best.
This is not to say that all analysts are writing drivel, there are some really smart, dedicated people in the business. However, the economics motivate quantity over quality.
The fact of the matter is that there too many analysts and probably far too many investment banks and brokers out there. There are something like 40 analysts covering Microsoft today, Apple and Google probably have over 50. We read A LOT of equity research and any given stock probably has a dozen notes published about it every day. Almost all of it is filler. Again, this is not to say the analysts writing that research are bad, but their incentives drive them to publish constantly.
Turning back to MiFID II and the payment of research, it seems almost inevitable that the number of research analysts will shrink pretty drastically in coming years. Investors will become more discriminating in research consumption, but they will still pay. Somehow. We do not believe the industry will disappear, but it does need some serious restructuring.