New York, NY – One of the audience members at last week’s NYSSA Independent Research Uncovered panel, asked if the panelists thought the price of equity research would drop to zero like other goods or services whose industries have reached a mature stage of development. All the panelists scoffed (including the writer of this blog), suggesting that equity research was unlikely to be commoditized like telecommunications services, print advertising, or even equity trading given the value-added nature of the services provided. However, upon further reflection, I have to admit that given the continuation of certain trends, the price of some equity research could be commoditize sufficiently to pushed it to “near free” levels.
Not All Research At Risk
Before we proceed we need to be clear – we do not believe that the value of all equity research is likely to plunge to become “near free” goods. In fact, we think that some equity research provides significant intellectual value, much like the advice of the world’s best doctors, lawyers, consultants, or business executives.
However, we have to admit that the equity research industry has changed quite a bit over the past decade. As a result, we are not surprised that many investors feel that some types of equity research have become nearly worthless to them. The following is a discussion of four of the factors we believe has led to a commoditization and the resulting “free fall” in the price of this type of research.
Oversupply of Research
One reason that some types of equity research have lost value in recent years has been that the supply of it has greatly outstripped demand – particularly of traditional fundamental company research. For example, according to StarMine (a Thompson Reuters company), at least 30 analysts produce research coverage on Microsoft.
This total is actually much lower than the actual coverage for the firm as dozens of independent fundamental and quantitative research firms also produce regular research on the firm, in addition to the other alternative research firms, bloggers, and financial websites that produce commentary and content about the company.
Historically, much of this research was widely distributed to retail and institutional investors as a way to drive increased trading business with the investment bank or broker. However, in recent years, many firms have realized that the proliferation of their research was driving down the value of it. Consequently, many firms have started to control the distribution of their research much more tightly, with some firms going so far as to “firing clients” who did not pay them enough in commissions to warrant receiving the research.
In fact, to create scarcity some research providers have formally adopted “restricted” business models where they provide access to their research to a limited group of clients who pay more for the right to receive this research on a semi-exclusive basis.
Plunging Production Costs
Another reason that some equity research has fallen in value in recent years is that the cost to produce it has plunged due to technical innovation and other global market developments. Historically the cost of hiring analysts to collect and analyze data, the computers to process it, and a global communications infrastructure to distribute it were not affordable for any but the largest investment banks, brokerage houses, and money management firms in the world.
Labor costs for junior analysts have come under significant pressure in recent years as many firms have started taking advantage of the labor arbitrage associated with using outsourced analytical help from low cost centers like Eastern Europe, India, South America, and even China.
And while the cost of senior analysts remains relatively high, it is clear that even these costs have moderated in recent years as difficult market conditions and tighter research budgets have depressed the costs associated with hiring senior research analysts.
In addition, falling costs for other factors of production (like computer technology, analytic software, historical data, or telecommunications networks) have made it less costly for alternative research providers and buy-side clients to leverage these resources themselves to create their own competitive research teams.
We suspect that these developments have increased the supply of sell-side and alternative research, while simultaneously decreasing the demand for this type of research as the buy-side has been able to supply more and more of their research needs with internal resources.
Lack of Proprietary Edge or Insight
The lack of proprietary insight has also contributed to the commoditization of certain forms of equity research. This has taken place for a number of reasons. The passage of Regulation Fair Disclosure on August 15, 2000 is one obvious development which greatly reduced the proprietary edge of fundamental sell-side research.
Historically, sell-side analysts had developed unique relationships with company management which enabled them to gain an information edge about the near-term prospects of public companies. However since Reg FD was passed, company executives can no longer divulge meaningful insights about their companies to analysts that are not disclosed to all investors simultaneously. This means that sell-side research reports don’t have as many of these proprietary insights as they once had.
Many research firms have also suffered from the loss of analysts with deep industry experience. Tighter research budgets, or competition from the buy-side have caused many of the most experienced analysts to leave sell-side or alternative research firms. In fact, we suspect this is one of the reasons that buy-side use of expert networks has grown so much in the past 5 to 10 years, as they have found a way to replace the industry expertise that the sell-side had previously provided to them.
In the past, some of the best sell-side and alternative research providers spent a great deal of time and money engaging in their own proprietary primary research. Unfortunately, falling equity commissions, shrinking research budgets, and difficult market conditions have reduced many firms’ willingness to invest heavily in conducting this type of research. This, in turn, has reduced the proprietary data and unique insight offered by these firms.
Little Measurable Value
Most equity research firms promoted the analytical “value add” they produce, however, few of these firms’ trade ideas or investment recommendations actually produce consistent profitable results. In fact, it constantly amazes the staff at Integrity Research how many research firms are resistant to having their research recommendations tracked and measured, and even those that do don’t produce consistent returns over time.
Certainly, part of the problem comes from the fact that many research firms (particularly alternative research providers) do not spend much time focused on issues like investment timing, actively managing their recommendations to determine when to close out positions, how best to weight their ideas or recommendations based on conviction levels, etc. Typically institutional salespeople at sell-side firms handle this part of “managing” the firm’s trade ideas.
The four reasons discussed above are just a few of the factors that we feel have contributed to the commoditization of equity research and the devaluing of it with many buy-side investors. We suspect these factors have already pressured the price of sell-side and alternative equity research lower – particularly for firms that primary produce traditional fundamental research reports. However, firms that are able to balance these research reports with higher value offerings like trade ideas, access to analysts and/or industry experts, access to management, access to industry conferences, proprietary data collected from consistent primary research, and access to analysts’ financial models should be able to keep buy-side demand high and maintain the price of their research in the marketplace.