The role of equity research is to provide information to the market. A lack of information creates inefficiencies that result in stocks being misrepresented (whether over or undervalued). Analysts use their expertise and spend a lot of time analyzing a stock, its industry, and its peer group to provide earnings and valuation estimates. Research is valuable because it fills information gaps so that each individual investor does not need to analyze every stock. This division of labor makes the market more efficient.
The title of this article is a bit misleading because the role of research hasn't changed since the first trade occurred under the buttonwood tree on Manhattan Island. What has changed is the environments (bull and bear markets) that influence research.
Research in Bull and Bear Markets
In every bull market, some excesses become apparent only in the bear market that follows. Whether it is dotcoms or organic foods, each age has its mania that distorts the normal functioning of the market. In a rush to make money, rationality is the first casualty. Investors rush to jump on the bandwagon and the market over-allocates capital to the "hot" sector(s). This herd mentality is the reason why bull markets have funded so many "me-too" ideas throughout history.
Research is a function of the market and is influenced by these swings. In a bull market, investment bankers, the media and investors pressure analysts to focus on the hot sectors. Some analysts morph into promoters as they ride the market. Those analysts that remain, rational practitioners, are ignored, and their research reports go unread.
Seeking to blame someone for investment losses is a normal event in bear markets. It happened in the 1930s, 1970s, during the dot com crash and the financial crisis of 2008, too. Some of the criticisms are deserved, but generally, the need to provide information about companies has not changed.
How Equity Research Is Changing
To discuss the role of research in today's market, we need to differentiate between Wall Street research and other research. The major brokerages provide wall Street research—typically sell-side firms—both on and off Wall Street. Other research is produced by independent research firms and small boutique brokerage firms.
This differentiation is important. First, Wall Street research has become focused on large-cap, very liquid stocks, and ignores the majority of publicly traded stocks. To remain profitable, Wall Street firms have focused on big-cap stocks to generate highly lucrative investment banking deals and trade profits, but also face the daunting task of cutting costs.
Those companies that are likely to provide the research firms with sizable investment banking deals are the stocks that are determined worthy of being followed by the market. The stock's long-term investment potential is often secondary.
Other research is filling the information gap created by Wall Street. Independent research firms and boutique brokerage firms are providing research on the stocks that have been orphaned by Wall Street. This means that independent research firms are becoming a primary source of information on the majority of stocks, but investors are reluctant to pay for research because they don't know what they are paying for until well after the purchase. Unfortunately, not all research is worth buying, as the information can be inaccurate and misleading.
These days there is a great deal of research that is provided for free to clients via email. Even at essentially zero cost to the investor, a large majority of the research goes unread.
Who Pays for Research? Big Investors Do!
The ironic thing is that while research has proven to be valuable, individual investors do not seem to want to pay for it. This may be because, under the traditional system, brokerage houses provided research to gain and keep clients. Investors just had to ask their brokers for a report and received it at no charge. What seems to have gone unnoticed is that the investor commissions paid for that research.
A good indicator of the value of research is the amount institutional investors are willing to pay for it. Institutional investors typically hire their own analysts to gain a competitive edge over other investors. Although spending on equity research analysts has significantly declined in recent years, institutions may also pay for the sell-side research they receive (either with dollars or by giving the supplying brokerage firm trades to execute).
European regulations that went into effect in 2018, known as MiFID II, require asset managers to fund external research from their own profit and loss account (P&L) or through research payments that are tracked with clear audit trails. This will lead to billing clients for research and trading separately.
The Role of Fee-Based Research
Fee-based research increases market efficiency and bridges the gap between investors who want research (without paying) and companies who realize that Wall Street is not likely to provide research on their stock. This research provides information to the widest possible audience at no charge to the reader because the subject company has funded the research.
It is important to differentiate between objective fee-based research and research that is promotional. Objective fee-based research is similar to the role of your doctor. You pay a doctor not to tell you that you feel good, but to give you his or her professional and truthful opinion of your condition.
Legitimate fee-based research is a professional and objective analysis and opinion of a company's investment potential. Promotional research is short on analysis and full of hype. One example of this is the email reports and misleading social media posts about the penny stocks that will supposedly triple in a short time.
Legitimate fee-based research firms have the following characteristics:
- They provide analytical, not promotional services.
- They are paid a set annual fee in cash; they do not accept any form of equity, which may cause conflicts of interest.
- They provide full and clear disclosure of the relationship between the company and the research firm so investors can evaluate objectivity.
Companies that engage a legitimate fee-based research firm to analyze their stock are trying to get information to investors and improve market efficiency.
Such a company is making the following important statements:
- It believes its shares are undervalued because investors are not aware of the company.
- It is aware that Wall Street is no longer an option.
- It believes that its investment potential can withstand objective analysis.
The National Investor Relations Institute (NIRI) was probably the first group to recognize the need for fee-based research. In January 2002, NIRI issued a letter emphasizing the need for small-cap companies to find alternatives to Wall Street research to get their information to investors.
The Bottom Line
The reputation and credibility of a company and research firm depends on the efforts they make to inform investors. A company does not want to be tarnished by being associated with unreliable or misleading research. Similarly, a research firm will only want to analyze companies that have strong fundamentals and long-term investment potential. Fee-based research continues to provide a professional and objective analysis of a company's investment potential, although the market for its services remains challenged in the current business environment.