The equity research industry has had to contend with a wave of changes over the past few years. The growth of passive investing, increased in-house research capabilities, and new fintech challengers have all placed significant strains on the business model of a traditional equity analyst.
It was the implementation of the revised Markets in Financial Instruments Directive (known as Mifid II) in January 2018 that accelerated and exaggerated these trends in a huge shake-up of the industry. The onus is now on that same industry to keep up with these changes and stay relevant in this new world.
Unfortunately, a significant amount of traditional equity research today still gets it wrong. Analysts were largely forgiven for poor research in the old “bundled” world (where research and trading services were sold together). But now that there is an explicit price on each research note, it needs to improve.
Surely the true measurement of quality research in a post-Mifid II era is to help traders make a decision, one based upon a recommendation that is driven by a new and alternative theory, which ideally is presented to the client ahead of the next company update?
In today’s market, however, there are too many people analysing companies using methods and tools that are now outdated in the digital age. The result is a lack of substance or innovative views across most research. Therefore, it is no surprise that most investment institutions have stopped paying for it.
The role of technology
The only way to deliver true unique insight in today’s market is to use alternative data sets, that ignore bias and gut feeling. The analysts now delivering the highest quality research are not afraid to embrace new technologies to analyse their stocks.
This could be using satellite imagery to demonstrate footfall on the high streets, analysing Twitter feeds to show sentiment, or even methods such as natural language processing on a chief executive’s talking updates.
In particular, small and mid-cap equities are the hunting ground for active fund managers, and continue to be where the biggest growth opportunities remain. For fund managers, it is crucial to find the analysts or research firms who deliver a good service, to provide the edge over their competitors, and deliver returns for their clients.
However, while boutique analysts are starting to bring a fresh approach to research, most of the traditional houses are yet to embrace change, and we have seen a decline in both the quality and quantity of investment research produced.
A lack of liquidity
The decline of more traditional equity research means coverage of stocks will be focused on the larger end of the market. Under-pressure analysts will be less likely to take a risk producing research on obscure smaller caps when they know that blue chips will continue to drive the trading flows.
Meanwhile, smaller research houses will be unwilling to take risks too. A few wrong calls and they will be out of business.
This trend – coupled with the increasing adoption of passive products in the UK market – will lead to increased investment in large cap stocks and a more pedestrian investment climate. This means even more consolidation of assets in UK large caps, and a reduction in liquidity for the smaller end of the market.
Even for those who have had a buy recommendation for a small cap stock, it can be difficult to find the other side or to get a risk price, even in today’s market. This trend can only continue, and will help passives grow even further.
Over the long term, a focus on large cap indices from both research houses and investors means that we could see a hit to smaller company initial public offerings, largely due to a lack of investment appetite, meaning fundraising will need to come from other sources.
If interest rates remain lower for longer, it is far more attractive for a company to issue a bond, because the payments are low and they don’t have to pay a dividend. Bonds also come with the bonus of not giving away a share of their company.
Crunch time for research
In a Mifid II world, it is more important than ever for research houses to stay relevant. The quality of research is under forensic measurement like it has never been before.
However, the market has not yet found a natural accepted level for what the value of a typical single stock research note should be.
The buy-side will continue to pay for small cap research for the next 18 months, in order to decide who the best providers are, and what “reasonable” research houses actually look like. Only when that point is reached will they have enough data to make informed decisions on whether or not it is more economical to do their own research.
This is the window of opportunity for research houses. This means embracing new tools to produce content that is interesting to read, insightful, and unique. A failure to adapt to the new “normal” could be very costly.