Guest comment: Equity research under fire

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Back in September 2004 I wrote an article about the state of sellside research. Now over a year later let's look at the current state of market: Equity research is still alive but being attacked from all corners.

Where are the attacks coming from? Unbundling, cost, value and independence.

1. Unbundling rules in January have forced fund managers to account separately for the cost of execution and research services they purchase from brokers.

This sets a precedent as for the first time research will be seen as an individual business. This will dramatically change the business and also lead to the departure of several analysts from the industry as they simply "won't be worth it". We will start to see only the revenue-generating, entrepreneurial type of researcher.

2. Cost is always a major issue, but since the equity research heydays of 2000/01 we have seen dramatic changes both in personnel and salary levels. Pay is simply not where it used to be.

Current salaries for lead analysts in the big sectors such as Banks and Pharmaceuticals are still high but not in the same league as the previous top Telecoms analysts of the millennium. We are seeing some of the senior analysts in other sectors being replaced by associates who are getting more coverage at an earlier stage but are also much cheaper than the existing senior analysts who are Institutional Investor and Extel ranked.

Research teams have been dramatically reduced, which does lead to reduced costs despite increased stock coverage. Another cost-cutting tactic we're seeing is that more and more of the investment banks and brokerages are recruiting more of their staff directly through in-house procedures of direct advertising and headhunting. This has affected us recruitment folk but the good recruiters always manage to find new clients and candidates that generate fees.

3. The emphasis is now merely on providing value. Gone are the days of boring, paper wasting research that does not add any value. The demand is for providing added value research like one- or two-page trading ideas, short e-mails, thematic and insightful research that is brief and will add value immediately. The desire is to have revenue generators who make the right calls and are not afraid to be mavericks and produce confrontational research that challenges the consensus.

4. We are seeing the rise of independent research houses. For too long the sellside of the financial industry has been giving away research product as an incentive to clients to do other business. This has simply devalued the product in the eyes of just about every market participant. As a result in a post-Spitzer/unbundled world the economic rationale of sellside research has all but gone.

Independent research houses believe that a profitable broking model is achievable only if research comes first. Independent houses do not engage in market making and have no proprietary trading operations. Their analysts focus on an absolute return philosophy; they seek to generate ideas that make clients money.

They are free of traditional sellside constraints and have no corporate responsibilities. Their interests are completely aligned with their clients. This message also sometimes seems like a soundbite for some of the analysts at the bulge bracket banks!

Therefore, what do we have?

As I predicted back in 2004 we have seen a rise in independent research houses. Cost is a major issue that has led to dwindling research teams, greater coverage, reduced salaries and more departures from the industry.

Unbundling is going to settle the players from the amateurs with only those who are entrepreneurial revenue producers with value sticking around. Darwin's "Survival of the Fittest" remains very true for an equity researcher today.