Executive Summary
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Equity research provided by investment banks, broker dealers, and independent researchers has an important influence on share prices.
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Research analysts are a very important constituency for the managers of quoted companies.
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Many major investment banks were accused of publishing biased research during the 1990s stock market boom to win higher-margin corporate finance business.
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Regulatory changes, starting in the United States and copied internationally after 2003, restricted contact between analysts and bankers and prevented analysts being paid on the basis of banking fees.
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Analysts are now more likely to offer unbiased opinions and to be more critical of companies.
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Company managers need to be careful to build good relationships with analysts through clear and consistent publication of information.
What Is Equity Research?
Equity research is the publication by analysts of reports, notes, and emails that offer an investment recommendation on the quoted stock of a company (typically buy, sell, or hold). The recommendation is supported by an investment case, financial forecasts, and a valuation. Reports vary enormously, from short updates of a page or less to substantial documents that analyze whole industries and companies in great detail.
Equity research is also done privately by some buy-side institutional investors and hedge funds, but this is not published externally.
Who Provides It and Why?
Public equity research is provided by three main types of supplier:
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Integrated investment banks that also offer equity broking and trading services plus a wide range of trading in other financial instruments, capital raising, and advisory services to companies.
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Broker dealers that offer equity broking and trading, but not corporate advisory services.
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Pure research providers.
The largest research departments are those in the global investment banks, which employ several hundred analysts each in a wide range of locations, and cover the majority of the world’s liquid stocks. Some cover the less liquid smaller-cap stocks too—though these are often covered by smaller investment banks and broker dealers who specialize in particular sectors (especially technology) or regions (especially emerging or frontier economies). These specialist areas require more local and specific knowledge, which niche providers may be better able to provide.
How Is Research Paid for?
Research is normally paid for entirely through commissions charged by equity traders. Research is best thought of as a service rather than a product, and consists of both the written output of analysts and access to the analysts themselves through phone calls, emails, and face to face meetings. The service is provided free at the point of delivery. Reports can be provided at an almost zero marginal cost to a very large number of potential clients. But the analyst’s time is far more valuable and is allocated only to those clients who are expected to pay for it.
Payment is made indirectly when the investor puts a buy or a sell trade through the firm for which the analyst works. The investor periodically informs the firm how much of the commission was allocated in compensation for the research service provided (as opposed to the pure cost of executing the trade), and for which analyst in particular. The research manager at the firm can then judge the commercial value of the analyst’s service and compensate him or her appropriately.
Pure research providers that do not trade receive a cash payment. Typically this is part of the commission earned by a separate bank or broker dealer, and is paid to the research firm on the instructions of the investor who wishes to use the research. Rarely do investors themselves pay for or commission research on a cash-fee basis.
An analyst’s provision of a research service to an investor client is not necessarily or even typically linked to commission received in trading in the stocks on which the analyst provides advice. The process of attributing the commission received during a year or quarter to the actual service provided by an analyst is therefore complicated, and the data are often poor.
Investment banks also have other motives for publishing research:
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To attract equity capital-raising business. Analyst coverage of a sector may be essential to win IPO (initial public offering) and other equity capital-raising business from companies in that sector. Good research helps to signal that the bank understands the equity markets in those sectors, and that the analyst would likely offer research on a company after its IPO, although the analyst is free to make the shares a “sell.”
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To advertise other higher-margin advisory services. Banks seeking to attract companies to use their advisory services, especially in M&A, may see research as a form of advertising; good-quality research may reflect well on the less public capabilities of the firm.
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To promote the general brand and credibility of the bank. Global investment banks in particular wish to be seen as credible commentators on all the main financial markets, products, and matters of the day.
Conflicts Arising from Investment Banking Coverage
The fundamental conflict of interest in any investment bank or other firm that offers services both to investors and to corporate clients is that raising capital involves dealing with the buyer and the seller. In an IPO, the bank is contracted to advise the owners of a company how best to sell their equity to investors. A high price is good for the owners, but not for the investors. But the investors are also clients of the firm, and the firm’s relationship with the investors is the main justification for their being competent to execute the IPO. Banks deal with this conflict in two ways:
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By segregating information flows behind “Chinese walls,” which strictly limits access to nonpublic and proprietary information.
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By segregating incentives: Staff dealing with the investor clients are compensated mainly, if not entirely, by their ability to offer a good service to them; the bankers who deal with the corporate clients are evaluated quite separately and according to how they have served them.
A second potential conflict arises in the publication of research by any broker dealer, including integrated investment banks. The short-term incentive of the firm publishing the research is to maximize commission by inducing clients to trade as much as possible—to “churn” their portfolios—at the expense of their ultimate investor customers (pension funds, mutual fund investors, etc.). Investment companies are of course mindful of this and, as professionals in the wholesale market, should be able to look after themselves.
The Global Settlement and Other Regulatory Changes in 2002–2004
In the late 1990s stock markets reached high levels on the back of a general enthusiasm for technology, media, and telecom (TMT) stocks. Many companies were listed on the stock market as IPOs. This business was very profitable for the sponsoring investment banks. When the stock market fell sharply in 2000–2001, many investors became concerned that the research on these companies had been biased and that analysts had knowingly recommended companies they secretly didn’t really value.
In 2001, Eliot Spitzer, District Attorney for the State of New York, started an investigation into allegations that analysts at the investment bank Merrill Lynch misrepresented their views because of the investment banking fees in which they would share. Emails were disclosed that led to a wider investigation of all the leading investment banks.
The bankruptcy of Enron in December 2001 led to the passing of the Sarbanes–Oxley Act on July 30, 2002. Among other provisions, it enabled the Securities and Exchange Commission (SEC) to limit the supervision of and compensation decisions concerning analysts to certain officials, essentially excluding corporate financiers from the process. The Act was followed by rule changes by the National Association of Securities Dealers (NASD) and the New York Stock Exchange, which managed the disclosure of conflicts of interest by research analysts.
In February 2003 the SEC introduced analyst certification, whereby analysts individually attested to the independence of their research and recommendations. There followed in April 2003 the Global Settlement, in which ten large investment banks signed a legal contract to undertake to insulate analyst compensation and evaluation from corporate finance influence, among other measures, and to pay a joint fine of US$1.4 billion. The banks were: Bear Stearns, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley, Salomon Smith Barney, and UBS Warburg.
The key regulatory changes, including the separation of research analysts from the corporate finance business, were copied in rule changes by stock market regulators around the world. For example, in July 2004 the UK regulator—the Financial Services Authority (FSA)—introduced a rule that required firms producing research to tell their clients whether it met the FSA rules on impartiality. In the same year the European Union introduced the Market Abuse Directive, which required full disclosure of conflicts of interest concerning analysts.
Current Practice and Near-Term Prospects
Research commissioned by the stock market regulators and done by independent academics broadly suggests that the recommendations of analysts are now less likely to be influenced by investment banking considerations. In particular, the distribution of buy and sell recommendations is much less unequal than it was in the late 1990s, when outright sell recommendations were extremely rare on Wall Street. There remain more buys than sells at most banks, but this is likely explained by a combination of analyst optimism and the commercial fact that there are always more opportunities for a buy (anybody can buy) than for sells (only existing holders can sell).
Investment professionals no longer complain about biased or tainted equity research, although they may still doubt the quality or commercial value of much of the research that is produced.
Companies and Equity Research Analysts
Analysts, no longer facing incentives to be kind about companies with which their corporate finance colleagues do business, are correspondingly able to be more critical of companies. Analysts’ opinions influence investors and can raise or lower a company’s cost of capital. Companies are well advised to try to keep analysts onside. They are not advised to copy the lawsuit by LVMH (Moët Hennessy Louis Vuitton) against Morgan Stanley in 2002. A French court initially ruled that a Morgan Stanley analyst had allegedly denigrated the company, and fined the bank €30 million. In 2006, the Paris Court of Appeal overturned most of the original findings and canceled the damages.
Any remaining bias in analysts’ views results from the desire not to offend a company’s management and risk exclusion from corporate events and meetings. But legally companies must disclose material information in a fully public way, so excluding an analyst is either impossible or largely symbolic. Well-established and influential analysts therefore feel emboldened to write candidly about their views of companies and their management, though most are careful to avoid gratuitous offence. Companies can best deal with equity research analysts by being frank, consistent, and helpful.
Making It Happen
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Leaders of stock market quoted companies need to take analysts very seriously because they influence investor perceptions of companies.
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Analysts value transparency, clarity, consistency of disclosure, and as much operating information as can be given without compromising a company’s commercial position.
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They also value access to senior management—not just the CFO—and appropriate site visits that provide real information about a company’s business.
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Long-term credibility with analysts is built by stating and repeatedly referring to key targets and candid accounts of reasons for failing to hit them. That credibility translates into a lower cost of capital and higher stockholder value.
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