New York, NY – In the past few years, the team at Integrity Research Associates has contended that the buy-side would continue hiring more equity analysts due to a variety of factors, including decreased sell-side research coverage and the declining perceived value of sell-side research. However, we also expect that this rise in buy-side analysts will actually lead to an increase in the use of external research in the future as analysts search for tools to increase their productivity, and proprietary data and content to help them analyze the large universe of companies they must cover. Integrity’s Buy-Side Research Outlook The team at Integrity Research expects that buy-side institutions will increase their spending on their internal research capabilities by 28.8% over the next few years from $5.8 billion in 2006 to $7.4 billion in 2011. This increase includes institutional investors’ spending on their research analysts, and the market data, analytic tools, historical databases, IT infrastructure, etc. to support these analysts. This total DOES NOT include the buy-side’s spending on the sell-side and alternative research they also purchase to support their investment process. Sell-Side Research Coverage As we mentioned in recent posts, most sell-side investment banks and broker-dealers have slashed their coverage of US publicly traded companies in recent years as equity commissions have fallen and IPO volumes have shrunk. According to data from Thomson Financial, the number of investment analysts working for the 10 largest investment banks declined 21% to 2,641 as of November, 2006 from 3,364 analysts in 2001, according to data from Thomson Financial. This trend is consistent with estimates provided by consultancy, The Tabb Group, which estimates that the total number of sell-side analysts fell from 16,200 analysts in 2000 to 9,300 in 2006. They expect this trend will continue as the number of sell-side analysts fall to 6,000 by 2008.
This decline in the number of sell-side analysts has resulted in a sharp reduction in the number of companies that receive research coverage. According to Reuters Research, between January 2002 and June 2006, 703 public companies have been orphaned by research analysts. As a result, almost 35% of all public companies receive no analyst coverage at all, while an additional 30% of all publicly traded companies are “under covered” (they have less than 3 analysts covering them). This decline in sell-side research coverage has had a significant impact on the buy-side, forcing many firms to increase the number of analysts they have on staff and raise the number of companies each buy-side analyst must try to cover. Perceived Value of Sell-Side Research
Another major change that has taken place in recent years has been the buy-side’s perception of the value of most sell-side research. Historically, investment managers and mutual funds relied on the sell-side for much of its fundamental company and industry research, as well as unique investment ideas. However, Reg FD and the Global Research Analyst Settlement have changed the value that buy-side firms place on sell-side research. Another major issue for the sell-side has been the growth in the number and importance of hedge funds in recent years. Unlike other investment managers, hedge funds typically desire investment research, trading ideas, and information that is more exclusive in nature. Unfortunately, investment banks and broker-dealers must distribute its published research and ideas broadly to all clients simultaneously. This fact reduces the value of sell-side research to many hedge funds. In fact, this is one reason that a number of bulge bracket investment banks and brokerage firms have moved some publishing analysts to the trading desk or made them salespeople. This enables these former analysts to verbally provide their insights to a discreet number of clients on a more exclusive basis. Despite this development, most buy-side firms have become less and less reliant on the sell-side for their investment research. In fact, this is consistent with the countless surveys which have revealed that buy-side analysts use the sell-side primarily to confirm ideas or investment decisions they generated themselves. It is also a reason why the buy-side cares less and less about an investment bank’s written research, and depends more on the sell-side for sales coverage and access to company management. Commission Transparency Prompts Change Another factor which has had an impact on the buy-side’s internalization of their own research capabilities has been the growing client scrutiny caused by commission transparency. A number of buy-side institutions have noted that their clients have started putting pressure on them for spending a large portion of their equity commissions on external research. The reason for this pressure is that historically many money managers sold pension funds and plan sponsors on their investment management prowess partially on the strength of their internal research capabilities. However, CSAs, CCAs and unbundling are now making these clients aware that their managers are relying extensively on external (sell-side) research. A number of these clients have started wondering aloud whether they have been overpaying their managers in the past. Some clients have gone so far as to mandate that they will only pay “execution only” commissions, and that any external research an investment manager wanted to purchase would come out of their own pockets (hard dollars). This has led some investment managers to increase their own internal research capabilities since the financial impact of such a move would be no different from paying for external research with hard dollars and it would enhance the buy-side firm’s competitive positioning. Buy-Side Analyst Staffing and Hiring Plans Our outlook is consistent with a recent survey conducted by Greenwich Associates which revealed that U.S. buy-side institutions increased the number of equity analysts they employed from just under 10 analysts in 2006 to between 11 and 12 analysts in 2007. This result reflected no change in the number of equity analysts at hedge funds, while mutual funds saw close to a 50% increase from just over 12 analysts in 2006 to slightly more than 18 analysts in 2007. Buy-side institutions also expect to continue hiring equity analysts in the coming years. In fact, the Greenwich survey shows that 47% of buy-side firms plan to increase the number of equity analysts they hire over the coming 12 months. Of this total, slightly more than half of all mutual funds and close to two-thirds of hedge funds expect to increase their hiring of equity analysts in the coming 12 months. Analyst Productivity Despite this increase in the number of buy-side equity analysts, the demands of their jobs do not seem to be getting any easier. Whereas the number of companies that buy-side analysts followed in 2007 slipped modestly to 54 companies, the number of industries they followed rose over 10% to more than 5 industry groups, while the number of company managements they met with rose over 80% to slightly more than 10 companies per year. Growing Demand for External Research One of the great paradoxes of the investment research business is the fact that increasing the buy-side spend on internal research will, in fact, increase the amount of external research required by institutional investors, though it will also change the type of research demanded by the buy-side. Based on the growing evidence collected by numerous firms, buy-side firms are both planning to hire more equity analysts AND spend more on certain types of research. Greenwich Associates reports that over the next twelve months, close to 40% of buy-side firms plan to increase their use of boutique broker and independent research. Our own research indicates that much of this increased demand for independent (alternative) research will result from buy-side analysts looking for high quality sources of primary data, proprietary content, and innovative research. In addition, we expect that buy-side firms will also look for tools to increase the productivity and reduce the strain on their analysts of covering so many companies. Consequently, we expect that the research providers that provide these kind of tools or produce this type of research will fare quite well in the coming years, while those firms that produce traditional fundamental company research or other more generic types of analyses will post meager growth (if at all).