Black September: Emerging Trends in Investment Research

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New York, NY – The Government takeover of FNMA and FHLMC, the bailout of AIG,  the failure of Bear Stearns and Lehman Brothers, the sale of Merrill Lynch to Bank of America, and the 40% plunge seen in the stock market in recent weeks is likely to have a profound and long lasting impact on the entire financial services industry –including the investment research business.  At times like these, we can look at all we have lost and mourn, or we can try to look ahead to see how the markets might change and how we might take advantage of the shifts that are likely to take place.

Today’s insightful blog post was written a few weeks ago by Brad West, the Co-Founder of Amba Research, a KPO provider that focuses on serving the financial services market.  In it, Mr. West gazes into his crystal ball and identifies the five major trends he thinks will develop in the investment research industry in the wake of the recent carnage on Wall Street.

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Amba Research co-founder Brad West (bradw@ambaresearch.com ) skipped work 22-26 September to stay home and try to determine what September 2008 portends for capital markets participants . His white paper concludes that the US investment research and capital markets industries will become relatively more competitive, more cost-conscious and less dominant worldwide. Amba Research sees evolution, not revolution. This article focuses on five research-related excerpts from the full report which deals with fifteen themes.  In descending order of probability, there are five research-relevant emerging trends:

1.            Decreased company and asset class coverage

2.            End of the bulge bracket research oligopoly

3.            Rise of sponsored research

4.            Outsourcing accelerates

5.            Unbundling continues

Decreased company and asset class coverage: Securities being covered will shrink further. Stock coverage numbers today are probably down 20% – 25% from their 2000 peaks. Preferreds, converts and high yields are probably even less well-covered, and offer prospectively superior risk-weighted returns. From the companies’ perspectives, being dropped from coverage decreases trading liquidity, limits their abilities to raise new capital and results in higher WACCs. Stock exchanges, too, will suffer from lower turnover-based fees.

End of the bulge bracket research oligopoly: Post-Spitzer, Wall Street’s chokehold on the production of research ideas for the professional fund manager had been easing. Now the hands are off the throat for good. With more listed companies certain to be uncovered by brokers (except perhaps on an automated, non-recommendation template basis), there’s an ever-growing opportunity. Meanwhile, commission sharing agreements (CSA’s) allow investors to pay any research provider and not just broker dealers. (Soft dollars do, too.) Independent research firms; boutiques such as Soleil Securities, Knight Securities and Redburn Partners; and even main line management and strategy consulting firms are all set to play larger roles in supplying company- and sector-research in the future. And don’t forget the market data vendors, either. Bloomberg, Thomson Reuters, Capital IQ, and/ or FactSet and one or two others may step in to fill the void as well. Expensive third party research done on a bespoke basis will become increasingly important in investors’ decision taking processes. Expert networks, provided that they aren’t heavily regulated, still have room for expansion.

Rise of Sponsored Research: Listed companies in future will have to pay to be covered unless they are Fortune 1000 incumbents or similar. From 2000 to 2004 the number of US companies covered by securities firms fell by over 16% (666 dropped from 4075 formerly covered names), and seems certain to have fallen further since. From a peak of 16,000 investment researchers in 2001, US analyst numbers fell to 9,000 in 2006. A 2007 study by NYU professors concluded that a loss of broker coverage resulted in an average 110 bp drop in a company’s share price. “Is there Life After Loss of Analyst Coverage?” (2007) by three other academics concluded that loss of coverage increased the risk of being acquired by 42% and of being delisted by 26%. While there are questions of causality, it’s fair to say that research coverage creates wealth for a company’s shareholders. In future “Who pays?” will become an increasingly apt question.

In 2003 the Singapore Stock Exchange (SGX) launched the Research Incentive Program (“RIP”) whereby listed main or secondary board companies wishing to be covered by an SGX-appointed firm could do so on a paid basis (with the MAS subsidizing part of the annual S$5,000 coverage fee per broker). Following in SGX’s footsteps, in May 2008 the London Stock Exchange (through newly-formed PSQ Analytics) announced that Main Board and AIM companies wishing to have non-recommendation broker research produced in a standard format could do so by paying £10,000 p.a. to the LSE. The LSE in turn would assign (via PSQ) coverage to one of three companies: Pipal Research, a subsidiary of India-based and listed FirstSource; AIM-listed International Independent Institutional Research (ticker: IIR.L); and US-based independent doyen Argus Research.

As of September 2008, the LSE’s program does not seem to have yet gone live, while 153 SGX-listed companies are covered by the RIP. These are modest starts, but the research economic model is broken and the sell side isn’t going to subsidize research any more. Investors will also play an ever increasingly important role by directing money to reward specific analysts and even individual reports.

Outsourcing accelerates: “Greater cost pressures à more reliance on 3rd party outsourcers” is undoubtedly true in a “In the long run we’re all dead” fashion. What isn’t clear at present is whether securities firm closures, ensuing high analyst unemployment and temporarily lower wages are going to negate this trend towards more outsourcing and offshoring (including captives). In addition, in crises many firms (and people) retreat to familiar business methods and organizational models. They don’t experiment with unproven approaches, especially at the strategic level that would make winning their business interesting to Amba Research (or one of its competitors). This is the big challenge Knowledge Process Outsourcers (“KPOs”, or judgment-based outsourcers as contrasted with BPOs, rules-based outsourcers) face with the investment industry need never greater, but the obstacles to customer acceptance also formidable.

From the sell side, therefore, outsourcers face a mixed bag: proven demand, more aggressive management, but fewer in number (!) and lacking strong agency profitability to confer staying power. Institutional money managers have been largely uninvolved in outsourcing to date, with fewer cost pressures than the sell side and greater confidentiality concerns. The very largest hedge funds are shifting to a DIY research model augmented by using bespoke third parties (onshore and off). Taken collectively, the near demise of the large, independent investment bank full service research department isn’t that big a deal.

The great question mark is whether the fund management boards are going to dictate a change on policy to their own in-house analysts (much less their portfolio managers). If they do and decide that outsourcing leading to lower overall costs is a source of strategic advantage, then high level Invest Research Outsourcing (higher end, client-managed dedicated heads) and Knowledge Process Outsourcing (“KPO”) output-based, outsourcer-controlled work will surge. Enough medium-to-large fund managers should (based on economics) make a strategic commitment to outsourcing to grow the overall judgment-dependent outsourcing sector heads by 30%-50% p.a. over the foreseeable future.

But the reality is that the buy side is less cost-consciously managed than the sell side, and old habits die hard. So there may not be the handful of pioneering firms who outsource on a large scale, and so thoroughly succeed that they become industry bellwethers.As we often say to our staff, the founders set up Amba Research in 2003 to take advantage of pending structural changes in the way investment research was produced, consumed and paid for. It could be, however, that under the current circumstances, the pendulum has swung so far towards chaos that the end result will be less rather than more outsourcing expenditure through at least late 2009.

Note, too, that with greater regulation will come the need to produce more reports and track more information for compliance/ filing purposes. Outsourcing is tailor-made for complying with red tape.

Unbundling continues: The FSA and especially the S.E.C. haven’t made the big push towards unbundling (i.e., separate charges for execution, sales and research) that the founders of Amba expected when setting up the firm in 2003. The US and UK regulators are unlikely to be imposing unbundling in the next few years because the lower research attributable revenues resulting from pure unbundling might be enough to trigger the complete closure of some departments. If further unbundling is to occur, institutional money managers will lead the way. A few such as Fidelity have in the recent past paid banks cash for research (e.g. Lehman and Deutsche). Many leading fund managers are using CSA’s to reward brokers and third parties directly via commission set-asides. Other institutional investors should follow suit.

The preceding article was excerpted from a longer piece (www.ambaresearch.com/amba/news). In the months ahead, Amba Research will produce a series of follow-up white papers which delve more deeply into the more controversial of the above topics.

 

In the meantime, we welcome your thoughts on Black September: Emerging Trends in Capital Markets.

 

Brad West

Co-Founder

bradw@ambaresearch.com

 

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