New York, NY – Last Monday, Integrity wrote a blog about why we feel that the price of some forms of equity research could be pushed lower as buy-side clients express their dissatisfaction with the value of this research. As you might expect, some research firms were not pleased with our post. However, we need to make it clear that the team at Integrity Research is not pessimistic about the future of the alternative research industry. In fact, we think there are a number of reasons to be optimistic about the prospects for the equity research business, and the alternative research industry in particular. This blog reviews a few of these reasons.
Market Driven Business Model
One of the historic problems with sell-side equity research is that it is bundled with a wide variety of non-research services, including execution, capital commitment, sales support, management access, IPO allocations, prime brokerage, etc. making it extremely difficult to ascertain what clients are really paying for. Consequently, many sell-side research departments have never really understood what clients find valuable in their research products.
The independent research industry, on the other hand, lives or dies based on its ability to understand, produce, and get clients to pay for their research services in a discreet, and often unbundled, manner. While this can be a brutal way to make a living if you get it wrong, this market driven mechanism has forced alternative research firms to produce the kind of research that clients value the most and are willing to pay for.
Thus, while most sell-side research firms have better relationships with buy-side clients, we think that most alternative research firms have a much better idea of what types of research clients truly value, because they know what they are willing to pay for or not pay for. We believe this knowledge is one of the critical reasons that independent research as an industry will continue to flourish in the years to come.
Value-Added Client Focus
A second related reason we are optimistic about the future of the alternative research industry is because of the value-added focus of most firms in the space. Most alternative research firms understand that either they deliver more value to the client than they ask them to pay, or they won’t be able to stay in business for very long.
This value can take many forms, like generating profitable investment ideas, providing an information edge which can be leveraged in an actionable investment, helping clients to save time or money, helping reduce risk, and other benefits.
However, sell-side firms can get paid thousands of dollars for their “research” even if they don’t add tremendous “value-add” if they provide some of the other services we discussed above (like access to IPOs or capital commitment). This is one reason that many sell-side firms get “overpaid” for their research when compared to other alternative research firms who provide similar or higher value research (as measured by the broker vote).
Despite this inequality, we believe that alternative research firms will be served well in the future if they focus on adding value for investors. Of course, this will be particularly true if US regulators mandate increased transparency or even outright unbundling – developments that are likely to have a disproportionately larger impact on sell-side firms than on alternative research providers.
Run Research as Business
Another reason for optimism about the future of the alternative research industry is the fact that every firm in the industry – from the largest to the smallest – runs their research operation as a business for the purpose of generating a profit.
Very few sell-side firms, on the other hand, run their research departments to maximize the revenue and earnings of their research franchises. Instead, sell-side research departments are typically seen as cost centers that serve a wide range of business units within the bank, including investment banking, equity sales and trading, asset management, proprietary trading, prime brokerage, corporate strategy and development, etc. As a result of these varied clients, and the myriad of conflicts of interest associated with serving so many different masters, it becomes difficult, if not impossible to do a good job of serving one specific client, like the buy-side investor community.
In addition, a firm that is run like a cost center can make a number of decisions that don’t make obvious commercial sense because they don’t really need to, whereas research firms that don’t make smart commercial decisions are not likely to remain in business for long.
Lower Cost Structure
A related reason we are optimistic about the future of the alternative research industry is because most independent research providers have significantly lower cost structures than their sell-side brethren. This factor means that most independent research firms have considerably more price flexibility than sell-side firms – an important issue in difficult market conditions like we face at present.
Some might argue that this means that research analysts cannot make as much working for alternative research providers as they can for sell-side firms. Of course, that is the case in some instances, we have seen a growing trend where ex-sell-side analysts have been able to move to the alternative research industry and make similar compensation as they did on the sell-side.
For example, one alternative research firm, ISI has recently been competing directly with the sell-side for talent by hiring a number of II ranked analysts. In addition, a number of former sell-side analysts have seen considerable financial opportunity as independents and have started their own businesses, including Dana Telsey, Ed Wolfe, Ivy Zelman, Meredith Whitney, and Stuart Graham.
While most independent research firms don’t have the payrolls of sell-side firms, the real cost savings for indies comes from lower support and overhead costs – which can exceed $200,000 per person at some of the nation’s largest investment banks and brokerage firms.
Innovative Culture
Probably the most important reason for optimism about the future of the alternative research industry is the innovation and creativity associated with this segment. The greatest innovation in most industries comes from small nimble players that are able to identify market opportunities and develop targeted solutions to fill them. Once these start-up firms attain market traction they become attractive acquisition candidates for larger firms with greater brand names, distribution, economies of scale, etc.
This trend is clearly the case in the research industry. A number of brand new types of successful research products or services have been started by innovative firms like Behind the Numbers (forensic accounting / quality of earnings), Gerson Lehrman (expert networks), Kapow and First Rain (search-based research), Majestic Research (data mining), KLD (environmental, social, and governance research), Business Intelligence Advisors (behavioral intelligence), or Tamale RMS (Research Management Systems).
However, some successful independent research firms actually identified their market opportunity by evaluating what investors valued in the traditional sell-side research offering, unbundling it, and perfecting the model to succeed as a stand alone service. A few of these firms include OTR (channel checks), Ned Davis Research (Investment Strategy), Sidoti & Company (Small Cap Research), and more recently Hanley & Associates (Management Access).
Summary
As you can see, Integrity Research Associates is optimistic about the future of the alternative research business for a number of reasons, including a market driven business model, a value-added client focus, a business approach, a lower cost structure, and an innovative culture. As long as institutional investors continue to search for alpha, we suspect independent research firms will develop new types of investment research services to provide them with the informational edge they are looking for. And as long as they are successful in doing this, we think the alternative research industry will continue to grow and prosper.