Investment banks ("sell-side") spend several $billion per annum globally creating equity research for investment clients ("buy-side"). Despite recent cutbacks, sell-side firms continue to provide equity research. Sell-side research should add significant value to investors’ understanding of quoted companies, and improve the quality of market information. Yet despite sizable resources and rewards unmatched in any other field of analytical research, sell-side research consistently:
- Misses most major insights or turning points in company analysis;
- Errs persistently to Buy recommendations and uncritical stances supporting current company policies or fads;
- Follows consensus forecasts and views;
- Prioritises client marketing over fundamental research;
- Focuses on short to medium term valuation formulae, rather than long term.
Some of these failures can be traced to the lack of transparency in commercial relationships between sell-side and buy-side:
- Buy-side institutions are loath to make open, direct and significant payments for specified research services;
- Research ‘cover’ to defend buy-side decisions comes bundled in dealing costs;
- Masked research costs shift focus and power within investment banks towards corporate fee and proprietary trading income;
- Equity analysts are conflicted, having to provide research for clients, but also contribute to corporate and trading income.
Eliminating ‘softing’ and ‘unbundling’ research has been a longstanding financial reform goal. Quality research should easily stand apart from corporate client and proprietary trading pressures. Yet firms offering unbundled research services remain mostly specialist boutiques. One legal and one voluntary initiative attempted to address these weaknesses:
- The Spitzer settlement in December 2002 aimed to create a level playing field in which buy-side investors accessed sell-side research transparently. Since then, research disclosures proliferate (more ‘red tape’) but fail to alter the preponderance of Buy recommendations and favourable research on each bank’s own corporate clients.
- The European Enhanced Analytics Initiative (EAI) in 2004 sought to encourage long-term, extra-financial research beyond short term financials. EAI linked 5% of participating buy-side institutions’ annual commission with a public ranking of sell-side competency. EAI attracted significant research from over a dozen bulge bracket and other leading banks, but failed to supplant the fully-bundled corporate, trading and commission packages. In 2008 EAI merged into the Principles of Responsible Investment initiative leaving unanswered questions about the future of Environmental Social & Governance (ESG).
Arguably only legally enforced separation of corporate, trading and broking functions (i.e. break-up of integrated investment banks) could achieve full transparency and independence in the supply of equity research. In the absence of political support for fundamental reform, the following three manageable steps might improve research quality:
- Full disclosure by sell-side and buy-side of all commission contracts;
- Compulsory publication by sell-side institutions of their recommendation balance (Buy/Hold/Sell) for:
- All covered stocks, and
- Corporate client stocks;
- Naming and shaming corporate managements who deny access to non-favourable analysts (‘analyst freeze-out’).
These are modest steps and simple. They would not eradicate the failings of sell-side research but they might encourage buy-side firms to see long term advantages in paying for independent, questioning sell-side research. If these modest proposals are too radical for regulation, one must question the sincerity of any desire to improve. If these proposals are too modest, then let’s welcome a sincere debate about transparency of fees, independence of research and the structure of financial services itself.