New York – In response to our last week’s blog about the paid-for or issuer sponsored research model. Because of the article we were referring to, the news about the model was fairly negative. And while we did indicate that there were providers of issuer-paid research that do a good job, we would like to clarify that further in this blog. There are currently 41 paid-for equity research providers in the Integrity Research database.
After the blog was posted we received some communication from a paid-for model shop, called Fundamental Research Corporation. Fundamental Research Corp. is a Vancouver-based issuer-paid research shop that recently wrote an article in the CFA Institute Magazine about the proper process to abide by to provide value to investors within this model. They also point out that there are conflicts within the sell-side model (or any model), if they are not managed properly.
One indictment against the model is the fact that the majority of the recommendations made are buy recommendations. We note, however, that while this is an issue, there is almost certainly a biased towards small cap companies buying coverage when the results are likely to be favorable (self-selection), rather than negative.
The often heard reason for paid-for research is that it provides information on the small cap stocks that would otherwise have no coverage, owing to their low levels of trade volume. This argument is entirely appropriate, since algorithmic and high-frequency trading seem to be pushing the trend toward ever larger, higher volume stocks. This is because these investment styles all depend on highly liquid securities to avoid liquidity risks inherent in the lower volume stocks. So having established that there is a place for paid-for research the real question is whether the policies and procedures are sufficient and if so whether they are being enforced diligently.
Here is a listing of the rules and regulations that are listed in the article. Certainly, there are a number of other compliance issues which apply to any research shop, but these are the policies that relate specifically to the paid-for model. First, the research firm must get paid up front in cash (not stock). This payment needs to be disclosed in the research disclaimers on every report. Additionally, the contract for coverage should be for at least 4 quarters, so that any change in conditions can be freely divulged by the analyst. Second, the covered firm must sign an agreement protecting the analyst’s independence, meaning that the analyst will not be interfered with by the covered company in any way over the coverage contract period. Third, research providers should employ full time analysts. This is an internal guideline related more to the quality and consistency of the reports than to the conflicts. Fourth, the research firm should have paid subscribers to its research. When the research firm is being judged on the quality of the recommendations they provide to investors, they are likely to be more analytically critical of the covered firms. Fifth, the research firm should be transparent about the percentage of buys, holds and sells it has issued.
Even if the research provider has a large number of buys in its portfolio, it does not necessarily mean that the investor is being disserved. As such, it is important from a transparency perspective for research firms, particularly those with a paid-for model maintain an independent assessment of their overall research performance. If one invested in every recommendation the research shop made, what would have been the return to the investor.
As part of its transparency efforts, Fundamental Research Corp. is being tracked by a third-party performance evaluation service called Investars. Investars allows investors to compare the performance of research providers by taking their buy, sell and hold positions and tracking performance across a universe of research providers. This allows all research firms that issues buy, sell hold recommendations to be compared to each other on an apples-to-apples basis.
So while there are flaws in the paid-for model, there are a careful few research providers that maintain strong policies and procedures to counteract those potential conflicts.
Note: Integrity Research has not conducted any analysis of the actual practices of Fundamental Research Corporation and is relying on the published policies and procedures on an as stated basis.