The following is a guest article from Randle Reece, an equity research analyst who recently lost his job when Avondale Partners exited its cash equities business this past March. Reece has spent most of his career as a buy-side analyst, in addition to being an investor relations officer (bio is at the bottom of this page).
The list of the fallen in US sell-side equity research grew longer in the past 18 months: BB&T, Brean, CLSA, Nomura, Sterne Agee/CRT, and my former employer, Avondale Partners.
Global investment banks are spending about $3.5 billion this year to fund equity research operations, compared with more than $8 billion in 2008, says Frost Consulting. Over the same span, about $1 trillion has flowed out of active asset management in the United States, most of that being captured by passive strategies such as indexing. Passive funds are approaching 50% of US fund assets under management, as calculated by EPFR Global. That figure was only 30% in 2010.
A key driver of this shift toward passive investing is the growth of the investment advice industry. Retail stock brokers have been replaced by fee-based financial planners and advisors. Instead of being paid on trading commissions, financial advisors earn fees based on clients’ AUM. This important change makes advisors sensitive to trading and investing costs—and naturally, advisors love the low cost and easy value-added of index funds and ETFs.
In other words, actively managed funds are at a marketing disadvantage, as the universe of retail financial advisors – growing at a 5% CAGR (Source: US Bureau of Labor Statistics) – pushes passive.
Business media love to bash sell-side research, but regardless of the product’s qualitative limitations, nobody should wonder why the industry is in serious decline. Money spent on research is a direct function of actively managed AUM, and this alone is enough to explain why the equity research industry is about 40% of its pre-Great Recession peak.
Playing a major role, no doubt, has been the decline of equity capital markets activity: only 105 initial public offerings in 2016, lowest since 2009. Secondary offerings were similarly depressed, as equity capital remained expensive compared with the miniscule cost of debt financing.
Why does sell-side equity research exist? If one believes the tales told by The Economist and the Financial Times, sell-side research aims to shill for the stocks of investment banking clients, foment churn in other equities (to be monetized in the form of trading commissions), create “corporate access” events, and perhaps bring fund managers some information about companies and industries.
My career has been almost evenly split between buy- and sell-side research. I’ve been a creator and a consumer. Based on my history of doing and using equity research, I have four main conclusions about the business.
Ratings and price targets should not exist.
Year after year, at Avondale our institutional sales force brought back from their clients a loud-and-clear mandate: “We pay for corporate access.” Our revenue became heavily dependent on our ability to get executives of the companies we covered in front of investors – at conferences, in non-deal roadshows, at headquarters tours.
Pressure to provide corporate access conflicts with the sell-side tradition of providing stock ratings and price targets. An underperform rating makes it difficult for an analyst to have even a cursory relationship with an executive management team. Ratings are distorted by compromises analysts make to maintain relationships. Tell analysts their relationships are worth more than their ratings – and that’s what practically the whole buy side is saying – and the whole ratings game is thrown out of balance.
Further, the ratings structure inhibits an analyst’s ability to discuss a stock’s attractiveness in real time, reflecting current valuation (absolute and relative). Regulations shifted to the point where analysts were forbidden from saying anything that might conflict with previously published opinions. Stock prices change every day. Prices often are affected by quarter-end and seasonal influences that are temporary.
Analysts should be able to talk about their ideas from a real-time perspective. What’s my best idea today? How would I rank my names, in order of attractiveness? In order of fundamental qualities? What’s a range of possibilities – for earnings, for valuation?
All the staples of sell-side research seem illogical to me – single-point price targets, based on static assumptions about potential earnings and valuation multiples. In my view, the custom of providing ratings and targets encourages this overly rigid approach to making recommendations. It has been my side hobby, for a few years, to experiment with financial scenario models that do not result in single estimates of revenues and earnings. Instead of talking so much about estimates vs. consensus, investors should fixate on 1) what range of long-term possibilities is implied in current valuation, 2) what range of outcomes is probable, and 3) does that mean the asset is mispriced?
We could have robust discussions about intrinsic and potential values of stocks, upside/downside scenarios, opportunities and risks – all the important decision points – without talking a moment about ratings and price targets. In truth, I had many discussions with investors that went just like that. Ratings and price targets inhibit the usefulness of sell-side research and should be eliminated.
Besides, virtually all rating systems are relative – based on a stock’s anticipated performance vs. the broader stock market. No analyst creates a marketwide forecast on which to base an individual stock rating. But the system implies we do, and that’s also wrong.
Sell-side research remains plagued with conflicts of interest.
The collapse of equity trading commission rates (competed down to near-zero) and trading volumes (diminished by the decline in active management and the extinction of retail stock brokerage) wounded the broker-dealer business model. But the meager activity in equity capital markets is crushing it.
Most broker-dealers had tried to operate sales, trading and research close to breakeven, with profits coming from investment banking. Sales-trading-research enabled the lucrative equity capital-raising business. Regardless of regulators’ efforts to disconnect banking from analysts’ pay, it has never been more obvious. Sell-side research has been funded by investment banking, and without it, firms are going out of business.
In Europe, implementation of MiFID II is forcing investment banks to unbundle research and trading. The US market has only inched toward such a model. Determining a market value for equity research is only the first challenge. Sectors and industries wax and wane through a business cycle. Why should investors pay for early-cyclical research in years when the economy is past the midpoint of its cycle? Then, how can early-cyclical analysts make a living?
Bankability of sector/industry coverage determines where broker-dealers invest in research. This force led to overinvestment in technology and healthcare analysts. In the past 12 months, financials, industrials and consumer stocks performed well, while the universe of analysts covering those groups continued to dwindle.
The research-using market has not developed enough incentives to focus independent research analysts on identifying the most/least attractive stocks in the whole stock market. Investors might claim to want that, but their dollars say otherwise.
Independent equity research can improve active management.
Institutional investors vary greatly in strategies, ranging from massively diversified to highly concentrated. Regardless of whether the strategy is deep and narrow, or wide and shallow, investors always need information flow and new ideas. Asset prices are inefficient, and inefficiency can persist despite the stock market’s awesome collective intelligence.
Why was one able to buy shares of AMN Healthcare Services at $10-11 in spring 2014 and then sell them at $40 within 14 months? Why did the stock price of Monster Worldwide reach $25 in 2010, only to lose 80% of its value within two years? How did LinkedIn shares dip below $100 late in 2012, then soar past $250 within nine months (and return to $100 in early 2016)? Did you buy Facebook (recently $150 a share) at $18 (2012), or $23 (2013), or $55 (2014), or $75 (2015), or $100 (2016)?
Good, independent equity research can help investors recognize these extraordinary opportunities. An analyst focused tightly on a group of related stocks develops industry- and company-specific knowledge and historical perspective. An equity analyst is of greatest value in those moments when the market’s herd behavior detaches stock prices from companies’ intrinsic value. It happens more often than finance theory claims it should.
Investors used me to help them get to speed quickly on the stocks I followed. Analysts’ written reports, company filings, and conference call transcripts typically dance around – but don’t confront – the most important qualitative factors. Written research is nonconfrontational; FINRA standards push analysts to use muted language and conform to the tradition of blandness. Moreover, sell-side analysts must be ever-conscious of relations with company executives. Investors have made it obvious: Those relationships are analysts’ most important assets.
That is why the live, analyst-to-investor conversation is invaluable. The two-way conversation between an intrigued investor and an experienced analyst provides swift, dynamic information flow that speeds the investor toward making the call on a stock. Written reports can be so wishy-washy that they are counterproductive. A research analyst brings the greatest value with current information in context with real-time prices. Regulators have been moving in the opposite direction, making it harder for analysts to adjust their views without going through the often drawn-out publishing process.
Sometimes I wished my reports were not documents but dashboards, updated constantly with current prices, allowing me to change opinions and nuances and have those thoughts instantly distributed. The world operates at that speed. We need to catch up.
Independent equity research is likely to remain an unattractive business.
With so many finance opportunities available in growing industries, the brain-drain out of equity research should continue. We have yet to see fund flows out of active managers even begin to stabilize. If active AUM cannot grow, money managers will continue to reduce dollars spent on research.
Passive funds and ETFs continue to hold a tremendous marketing advantage. Active funds must achieve superb outperformance to compete. How many portfolio managers can meet that lofty standard? Where will the active vs. passive balance settle out? Will it be 40/60, 30/70?
At the recent rates of change, it would take quite a few more years for passive management to surpass 60% of AUM. With its market potential continuing to shrink, the equity research business is far from becoming a growth industry again. Good stockpickers are better off keeping their best ideas to themselves. I would have been.
Randle Reece was most recently Vice President, Senior Analyst at Avondale Partners, covering business services stocks, until Avondale Partners shut down its cash equities business in March 2017. Previous to Avondale, he was a buy-side analyst for over a decade with Waddell & Reed and Hoover Investment Management. He served as an IR professional for recruiting firm Staffmark, and began his career as an analyst for Stephens and Montgomery Securities. His LinkedIN profile can be accessed at: https://www.linkedin.com/in/randlereece/