Out of commission

It’s just not the same, being on the sell side. Over the past decade experienced analysts have retired, struck out on their own to launch independent research boutiques, started hedge funds and become IROs. There’s a familiar litany of events that changed the landscape of sell-side research forever: Reg FD leveled the playing field; decimalization accelerated the commission squeeze; Eliot Spitzer’s post-tech bubble Global Research Analyst Settlement slammed shut the pay door between research and investment banking; the internet, social media and increased compliance scrutiny narrowed the scope of the analyst’s role.  

As it scrambled for a new and sustainable business model, Wall Street took a dose of the medicine it often prescribed for the companies it analyzes – outsourcing – as it pushed labor-intensive number crunching to low-cost locales such as India, Malaysia and the Philippines.

Then, just as things seemed to be settling into a new normal, the market meltdown of 2008 once again sent the Street scrambling for solid footing. With trading volume off, new rounds of downsizings hit research departments. So the recent Greenwich Associates client survey reporting an ‘unexpected’ 12 percent drop in commissions paid on US equity trades instead of an anticipated 15 percent gain in the first quarter of 2011 seemed to be just one more hit to an already beaten-down sell side.

It also kept alive the question: is the sell side headed for, if not extinction, then irrelevance?

Old dogs, new tricks

The role of the sell side ‘needs to be redefined,’ asserts James Bianco, president of Chicago-based macroeconomic research firm Bianco Research. He questions both the value of much investment research and its cost to clients. Analysts put out ‘too much spin, too much PR,’ he says, and it’s most apparent when they ‘play along’ with the companies they follow in what he describes as an earnings guidance game.

Bianco believes companies’ forward-looking guidance, particularly when it changes, is important to investors, but the backward-looking earnings surprise is meaningless. As evidence, he cites his own research on earnings surprises showing that over the past 50 quarters, more than half of actual reported quarterly results exceeded analysts’ mean estimates by 1 percent on average.

More recently, 70 percent of actual reported results exceeded the mean of analysts’ estimates over the previous 10 quarters, while the average ‘surprise’ grew to 3 percent.

If the sell side was truly providing independent estimates derived from its own analysis, the split should be closer to 50:50, Bianco argues. Even in the fourth quarter of 2008, ‘the worst quarter in years’, 50 percent of companies beat estimates, he says, adding that the sell side ‘got the great recession wrong. It completely missed it.’ Both industry-specific analysts and market strategists alike were ‘trying to one-up each other’ with bullish forecasts in mid-2008 at just the moment when they should have been earning their fees by forecasting the recession.

Research is focused on meeting the needs of short-term trading clients, Bianco says; as a result, it is focused on near-term numbers and company guidance. The consequence is that investors ‘make a nickel (on a trade) but lose $5 when the economy turns.’ He doesn’t fault company IROs for providing conservative guidance, however. ‘Companies are free to say whatever they want,’ he notes. ‘It’s up to the analyst community to cut through all of that and give us an honest assessment of what it thinks earnings are going to be.’

More, better, faster

Nicole McIntosh is vice president of IR for Waddell & Reed Financial, a Kansas City-based money manager and mutual fund company. As IRO within a publicly traded buy-side firm, she sees the street from both sides, and feels the ‘significant change in the quality of sell-side coverage’ over the past decade can be blamed in part on increasing pressure on the sell side ‘to do more with less’. Analysts are expected to publish more research notes on more companies and do it more quickly than ever before, she says. As a result, they have less time to give ‘deep thoughtful analysis’ to the individual companies they follow.

While she hasn’t changed how she deals with the sell side, McIntosh points out that the exit of more experienced analysts has changed what she talks to them about. She now spends more time educating analysts about the basics of her industry and responding to rumors or irrelevant developments because inexperienced analysts will hear some bit of news and ‘call me in panic’, even though what they are asking about is ‘a nit on a gnat’.

Zack Shafran, director of research at Waddell & Reed, is not ready to short the role of the sell side within his firm. One of the biggest changes he’s seen has been the growth in the number of companies he deals with. He credits this increase in part to independent boutiques with particular specialization and in part to the expansion of Waddell & Reed’s investment scope across more industries and geographies.

‘The sell side continues to play a very central role in supplementing our individual internal research process,’ Shafran notes, adding that while commission levels fell a few years ago, they have returned to near the level of three years go.

Shafran says earnings estimates are only one factor among several his portfolio managers look at when giving their biannual evaluation, which determines commission allocation among the sell-side firms he deals with. ‘We have to assess those things some people are good at,’ he says, pointing out that individual portfolio managers value different factors, including not just earnings estimates but also corporate access, written company and industry research, field trips, conferences and analyst service.

Small successes

The one area where Shafran has seen research suffer in recent years has been in the small/mid-cap arena, which he describes as a ‘very, very tough space (for the sell side) to make money’. One firm that seems to have figured it out is Milwaukee-based RW Baird. In the same Greenwich survey documenting shrinking commissions, Baird garners top market share in the small/mid-cap space and stands out in the client survey as the favorite, earning high marks for the quality of its small/mid-cap research product.

Jon Langenfeld, Baird’s co-director of equity research, points out that ratings, price targets and earnings estimates ‘are important but are not the number one or two reason equity research exists.’ Instead, he argues that equity research should be ‘the main source of a deep knowledge in a particular sector and day-to-day, week-to-week and quarter-to-quarter insight’ on key developments.

Baird’s research success is built on several factors, Langenfeld believes. In late 2008 and early 2009 ‘when the world was falling apart’ and other firms were laying analysts off, Baird not only kept its research team intact but also picked up four experienced analysts, bringing the total number of senior analysts to 41. While admitting that the total commission pool continues to decline across the industry, Langenfeld points out that a greater percentage of commission dollars is allocated to research than to execution, although he acknowledges that the sell side suffers from overcapacity, making it harder ‘to attract the best and the brightest’ into equity research as a career.

Nevertheless, Langenfeld is bullish on research, at least at Baird, where he says the culture is ‘very much focused on a team approach, not on the individual. We’re all on the same page.’

This article appeared in the October print edition of IR magazine.