Equity Analyst Reports Part 2: The Necessary Evil
In this second part of our examination of equity analyst reports, we are going to look at the following topics:
- The decline of the traditional equity research industry;
- The evolution of equity research;
- Why sell-side research is still useful.
The previous article that we published on this subject discussed the conflict of interest that almost inevitably emerges when sell-side equity analysts recommend certain trades. It is interesting to note that the number of such analysts is reducing steadily by about 10% between 2012 and 2015. Research spending is also predicted to reduce in the coming years.
There are three main factors underpinning this phenomenon, the recent economic climate, increasing government regulation, and the evolving business model. While the first two factors are transient, and will most certainly not last forever, the third can be significant for the future of the sell-side research.
The global financial crisis of 2008 has left a legacy on our financial eco-system. As a direct response to this crisis, the financial services industry has reduced spending and headcounts, with sell-side research being one of the main casualties. More recently, as the trade wars begin to heat up, economies and markets are getting more isolated and this may impact the global banks’ spending on research.
Government regulation has also affected the industry. We can trace it back to 2002 when the US Securities and Exchange Commission (SEC) passed the Regulation Fair Disclosure (Reg FD) bill, which prevented selective disclosures by companies to anyone, particularly equity analysts. This essentially affected analysts’ timely access to information. The US Dodd-Frank Act which was passed shortly after the global financial crisis, restricted access by financial institutions, diminishing the informational edge of sell-side analysts.
In Europe, the EU MiFID II regulation that was passed in 2018 compels investors and institutions to pay explicitly for research. It will no longer be possible for either brokerages or banks to file such research under trade costs, which will make sell-side research considerably more costly.
The most important factor affecting the equity research industry is changing business dynamics. The democratization of information on the market means that investors have the opportunity to follow less biased recommendations, and even conduct their own research. Traditional equity research is at a crossroads, with new business models facilitating access to independent equity research via mobile platforms. Companies such as Smartkarma and Estimize are revolutionizing the space with crowd-sourced independent research.
Alive and Kicking
However, it would be wrong to assume that sell-side research ceases to exist in the future. Investors now experience information overload and may find it difficult to differentiate the objective from bias. Sell-side reports may be unduly optimistic, but the consistent manner of their production means that they can be excellent reference material, and they can be particularly useful for smaller buy-side funds that cannot afford an in-house team, especially as a valuable source of investment ideas.
Another advantage of traditional sell-side research is that it generally encourages the trading environment, which tends to lead to increased market liquidity. In such a climate, more companies will tend to list, ensuring that exchanges enjoy a consistent and superior IPO pipeline. Naturally, this will tend to lead to an environment in which capital markets develop favorably. Research has also indicated that analyst recommendations do have a positive impact, with short-term trading based on analyst recommendations resulting in an average two-day return of up to 1.50%.
The inherent biases and weaknesses of sell-side equity research need to be understood so as to be used effectively by investors. Sell-side research should continue to play a significant role in the financial system and the financial markets.