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Home > Asset Management Best Practice > The Changing Role and Regulation of Equity Research

Asset Management Best Practice

The Changing Role and Regulation of Equity Research

by Simon Taylor

Executive Summary

  • Equity research provided by investment banks, broker dealers, and independent researchers has an important influence on share prices.

  • Research analysts are a very important constituency for the managers of quoted companies.

  • Many major investment banks were accused of publishing biased research during the 1990s stock market boom to win higher-margin corporate finance business.

  • Regulatory changes, starting in the United States and copied internationally after 2003, restricted contact between analysts and bankers and prevented analysts being paid on the basis of banking fees.

  • Analysts are now more likely to offer unbiased opinions and to be more critical of companies.

  • Company managers need to be careful to build good relationships with analysts through clear and consistent publication of information.

What Is Equity Research?

Equity research is the publication by analysts of reports, notes, and emails that offer an investment recommendation on the quoted stock of a company (typically buy, sell, or hold). The recommendation is supported by an investment case, financial forecasts, and a valuation. Reports vary enormously, from short updates of a page or less to substantial documents that analyze whole industries and companies in great detail.

Equity research is also done privately by some buy-side institutional investors and hedge funds, but this is not published externally.

Who Provides It and Why?

Public equity research is provided by three main types of supplier:

  • Integrated investment banks that also offer equity broking and trading services plus a wide range of trading in other financial instruments, capital raising, and advisory services to companies.

  • Broker dealers that offer equity broking and trading, but not corporate advisory services.

  • Pure research providers.

The largest research departments are those in the global investment banks, which employ several hundred analysts each in a wide range of locations, and cover the majority of the world’s liquid stocks. Some cover the less liquid smaller-cap stocks too—though these are often covered by smaller investment banks and broker dealers who specialize in particular sectors (especially technology) or regions (especially emerging or frontier economies). These specialist areas require more local and specific knowledge, which niche providers may be better able to provide.

How Is Research Paid for?

Research is normally paid for entirely through commissions charged by equity traders. Research is best thought of as a service rather than a product, and consists of both the written output of analysts and access to the analysts themselves through phone calls, emails, and face to face meetings. The service is provided free at the point of delivery. Reports can be provided at an almost zero marginal cost to a very large number of potential clients. But the analyst’s time is far more valuable and is allocated only to those clients who are expected to pay for it.

Payment is made indirectly when the investor puts a buy or a sell trade through the firm for which the analyst works. The investor periodically informs the firm how much of the commission was allocated in compensation for the research service provided (as opposed to the pure cost of executing the trade), and for which analyst in particular. The research manager at the firm can then judge the commercial value of the analyst’s service and compensate him or her appropriately.

Pure research providers that do not trade receive a cash payment. Typically this is part of the commission earned by a separate bank or broker dealer, and is paid to the research firm on the instructions of the investor who wishes to use the research. Rarely do investors themselves pay for or commission research on a cash-fee basis.

An analyst’s provision of a research service to an investor client is not necessarily or even typically linked to commission received in trading in the stocks on which the analyst provides advice. The process of attributing the commission received during a year or quarter to the actual service provided by an analyst is therefore complicated, and the data are often poor.

Investment banks also have other motives for publishing research:

  • To attract equity capital-raising business. Analyst coverage of a sector may be essential to win IPO (initial public offering) and other equity capital-raising business from companies in that sector. Good research helps to signal that the bank understands the equity markets in those sectors, and that the analyst would likely offer research on a company after its IPO, although the analyst is free to make the shares a “sell.”

  • To advertise other higher-margin advisory services. Banks seeking to attract companies to use their advisory services, especially in M&A, may see research as a form of advertising; good-quality research may reflect well on the less public capabilities of the firm.

  • To promote the general brand and credibility of the bank. Global investment banks in particular wish to be seen as credible commentators on all the main financial markets, products, and matters of the day.

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Further reading

Websites:

  • Most investment banks and brokerages that provide research restrict access to clients, but are normally happy to include companies in their distribution lists and to provide access to their web portals.
  • Standard & Poor’s is a large, independent, nonbank provider of research and has some useful resources on its website. Choose your region and select “Equity Research” from the “Products & Services” dropdown menu: www.standardandpoors.com
  • A very useful resource on the theory and practice of equity valuation is the home page of Aswath Damodaran of New York University: pages.stern.nyu.edu/~adamodar
  • Details of the Global Settlement are available at: www.sec.gov/news/speech/factsheet.htm and tinyurl.com/5uad96y

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