Institutional Investors and Research: A Landscape in Flux

On Friday I was speaking with a writer, Tiernan Ray, about harnessing the power of the Internet for investment research, among other issues. As he and I were talking I found myself having pretty well-defined views on the topic, e.g., the expanding use, power and impact of the Internet on investment research and its ramifications for traditional sell-side and independent research products. Tiernan commented that I should write a post addressing these issues. He was right. As a result, I wanted to be sure to give Tiernan credit for serving as the inspiration for this post.

So the key question that needs to be addressed: what are Institutional Investors really looking for from an externally-generated research product?

In order to consider this problem properly, I believe the analysis needs to take into account a few salient facts:

1. Institutional Investors are increasingly sophisticated, building ever-more robust internal research capabilities;
2. Institutional Investors suffer from an increasingly acute case of information overload, being bombarded with data, information and dreck from an array of sources;
3. Institutional Investors have increasingly abundant financial resources denominated in either hard- or soft-dollars at their disposal, giving them the ability to pay for new and valuable research products and services; and
4. Institutional Investors are facing an increasingly competitive investment landscape, with the structurally and demographically-fueled increase in AUM highlighting the fact that finding unique tradeable information and insights is more important than ever.

Ok, that's cool. But how do these facts impact the day-to-day behavior and attitudes of Institutional Investors? I can hear the following responses rolling off the tongues of a wide-range of buy-side pros:

1. "Don't give me a canned, verbose, broadly distributed research product, and, by the way, I really don't care about your Buy/Sell/Hold ratings or earnings models, so save the paper. I am smart and know these companies better than you, sh*thead. Your ratings, if anything, might serve as a contrarian indicator in my pricing models."
2. "Give me stuff I can't get myself, i.e., meetings with relevant senior executive officers. Yes, serving as as a relationship broker is one demonstrable way you can add value. Your skills as a secretary are highly valued by me. So do it fast, ok?"
3. "Thick reports, unless they are chock-full of differentiated, unique data, are virtually meaningless. Global sector perspectives have value if they are copiously researched and contain unusual, valuable data and insights. Most of the time, they don't. In that case, save it."
4. "I may be rolling in cash but I am really f*cking cheap. Mama needs new shoes, ok? I'll pay but only for valuable stuff, not that historic processed crap I'm used to getting. And don't pull that bullshit relationship card on me, ok? You used that one last year."

A little cynical, yes? I think not. But anyway, based upon my knowledge of the buy-side, what do Institutional Investors really want and need as part of their research process? I believe it is fair to operate on the assumption that in an increasingly unbundled world (research and commissions, that is), investors know exactly what they want and what they are willing to pay for. I think the list below includes some of the key items:

1. Unique and hard-to-access data on a global basis
2. Insider perspectives on business prospects
3. Access to subject-area domain experts
4. Understanding of "buzz" related to a company or a product
5. Intimate understanding of supply-chain relationships and the interdependencies among companies and their key suppliers
6. Getting 1-5 in a manner that doesn't chew up too much valuable time

There are many others but I think this is a pretty representative list. So in light of this list, how does the traditional sell-side research product stack up? How about the independent research offering? And what about alternative tools for research, data collection, financial intelligence and analysis?

Sell-Side Research: Old dog in need of new tricks

I still get sell-side research reports. Pretty much the same stuff I've seen for the last ten years, except maybe worse. Now I am being purposely general here - clearly not all sell-side research is bad, only some of it. But a lot of it. Reports generally come in three flavors, in my experience: (1) The broad company piece, which includes lots of text, lots of models and takes up lots of pages. I'm not sure I get much more from this than I do a thorough reading of the 10-K, 10-Qs and Proxy, however. But that's just me. (2) The periodic update piece, which is a very short blurb which says "Hey, Company X just released a new product" or "The Management of Company Y just made an announcement." And, oh yeah, there are some pithy sentences laying out the analyst's interpretation of the announcement. Says the buy-side analyst: "Sure, I saw this come over the wire. I know goddamn well how to interpret this information." Yawn. (3) The Sector Tome, which is a zillion pages and goes into macro themes for an industry with supporting pieces on each company. These can be pretty cool when well-written and well-researched. Otherwise, the authors should be taken away in shackles and dragged to eco-jail on charges of first-degree tree homicide.

Sell-side research also has the requisite Buy/Sell/Hold, which I don't think any self-respecting Institutional Investor really cares about. But investors do care about the meetings senior research analysts can set up with senior management of companies. And these management road shows are an important part of the value creation process for sell-side firms. And these sure cost less than having 300 research analysts globally. And I'm not sure that the current Wall Street research spend, which has dropped precipitously from its lofty highs around 2000 (when research budgets reached $700 million-$1 billion per year), is still low enough relative to the value created for the franchise. I'm not sure. But I am sure that much of the product that is generated by the sell-side is not given the desired weight by the buy-side. Namely because the value frequently isn't there. Look at the list above - how many of those six are truly addressed by traditional sell-side research? Maybe two? And this is a problem that will get fixed by natural market forces, the most dominant of which is the incredibly shrinking research department. So some new approaches are required in order for the sell-side research complex to remain relevant. Only time will tell if they are able to adapt to a changing world.

Independent Research: You need more than the Research Settlement to be relevant

Independent research has been a nice, value-added cottage industry for a long time. Ex-domain experts, economists, macro strategists, forensic accountants, etc., putting out a shingle, producing a solid piece of differentiated research and selling it by report or by subscription. I think of Howard Schilit's forensic accounting shop CFRA as one of these niche-oriented, value-added independent research providers. This worked pretty well for the research firms and the clients and represented a good way to augment one's mainstream knowledge base and homegrown research efforts. Then came the Research Settlement in the wake of "Blodget-gate" and the rest of it. Out of the nether-world sprung a bevvy of independent research writers, independent research distributors, and many others who wanted their piece of the Research Settlement gravy train. And what was once an industry characterized by moderate volume became very noisy very fast.  Very, very noisy.

As a result, we have a very croweded and confusing landscape in independent research-land, one which will rectify itself very, very soon. When the Settlement dollars run out and it becomes a business driven purely by buy-side demand, the wheat and chaff will be separated lickety-split. And this will be good. Because top independent research providers can almost be thought of as an extension of a buy-side research desk. As a buy-sider I've got knowledge, I've done research, I've got my thesis, but if I can buy research from deep domain experts that can complement my in-house work then I'll view that as money well-spent. Because I need all the smart perspectives and targeted, valuable data I can get my hands on. Because it is a competitive environment out there. And I've got money to spend on the right things that add value to my investment process.

Alternative Data Sources, Tools and Services: Focused resources for a dynamic environment

Over the past ten years a variety of companies have sprung up to make the lives of the Institutional Investor easier. These companies either better organize existing information to make it more usable, like CapitalIQ; provide easy access to experts who can add value to the investment process, like Gerson Lehrman Group; or offer platforms for rapidly identifying valuable information from the sea of noisy data out on the Internet, like my company, Monitor110. These types of companies all operate on the assumption the Institutional Investors are smart, don't want to be told what to do or how to do it, but to bring valuable intelligence to the investors' attention in a straight-forward, easy to consume manner. It is a fundamentally different paradigm than traditional sell-side research, which is set up to be something an investor looks at, reviews in conjunction with other analysts' views, follows the view they most agree with and trades with that firm. The alternative information  providers don't care about getting the trade. They care about getting paid a subscription fee for generating value and becoming embedded in a client's investment process. In short, they are valuable tools for helping the investor make better decisions. Very focused. Very clear value proposition. Very easy to incorporate into the existing investment process.

Conclusion: An a la carte world for the discerning investor

Has traditional sell-side research become marginalized? Yes. Can it fight its way back? Not to the level it once was, but it can become relevant again. How? By focusing on the ability to gather unique data and insights and to present them in a way that is easy and straight-forward for the Institutional Investor. I see many fewer 200-page tomes in our future. I do see the sell-side making better use of alternative information tools for their own research process, and delivering more data-driven, analytical pieces to their buy-side clients. I believe the independent research world will contract as well, as only the strong (read: value-added) survive in a brutal shake-out. That said, I can see high-quality independent research (as well as the alternative information providers) plugging some of the gaps left by the sell-side research contraction, as Wall Street research budgets continue to come under pressure as the buy-side is increasingly focused on easy access to capital and less on using commissions to pay for unwanted research spend. Finally, alternative information providers will continue to thrive as greater spend is devoted to these focused resources that help to more easily bring the planet's information to investors' fingertips. Whether it is CapitalIQ organizing financial statements, Gerson Lehrman organizing the world's experts or Monitor110 organizing the Internet for Institutional Investors, the overriding theme is the same: Helping Institutional Investors make money more easily through the use of powerful tools and networks. And if the sell-side internalizes these principles, I believe the sell-side can become a "buy" once again.

Comments

[Martin Rabkin]

Has anyone read TABB Group's 2006 report on the issue, The Future of Equity Research: a 360 Degree Perspective? From what I've read, the report analysed the current state of the equity research industry in the UK and the US, speaking to and using data from all sides: the asset manager and investment management firms that are the primary consumers of research; and research producers of all sorts – independent firms with no brokerage functions, and broker-dealers both with and without investment banking.

[Kris Tuttle]

The independent research space could certainly use a shakeout. I continue to be amazed at the lack of good product out there. Most sell-side firms are pushing out the same stuff. "Company XYZ lowers guidance, stock likely to fall."

I'm being a little unfair because some firms, like American Technology Group, have had some very good fundamental research calls in the past few months.

I think those hoping to survive as independent research providers need to really focus on the value they can add in the current environment. CFRA is a good example of what worked in the past. Today I think the bar is higher and only the best will do. That goes from quality of information, domain expertise and production values.

Services like Monitor110 and others in the hands of smart buy-side firms seem inevitable.

Domain expertise and the ability to map fundamental changes quickly to future impacts on business results and stock prices will remain a lucrative talent.

[Grace Nationville]

Thanks for the post.
Information Overload accurse in all levels, spaces.

We, humans, are in a course of progress, learning to manage our information society as opposed information (technology) managing us.

Another perspective on information overload watch here: http://nationville.com/

[Ben]

Excellent post. How does Monitor110 differentiate vs other platforms targeting the institutional investor such as Majestic and BuzzMetrics?

[Yaser Anwar]

There is an excellent academic study pertaining to this phenomenon.

Solving the Sell-Side Research Problem: Insights from Buy-Side Professionals

http://mba.tuck.dartmouth.edu/pages/faculty/kent.womack/working_papers/InsightsProfs.pdf

Sir, all round good post. Though you should have talked a little about the TOPS system developed by Marshall Wace & Paul Marshall to grade buy/sells of the analysts, that you had brought to my attention a while back.

It seems to be quite good, do you think it will see a wider adoption, especially in the US? And, why do you think it hasn't been adopted yet?

"The unique system of using algorithms to analyze the recommendations from salesmen and rank them to decide who wins Marshall Wace’s considerable business has paid off."

http://www.timesonline.co.uk/article/0,,5-1826166,00.html