Downgrading Sell-Side Research

Editor's Note: MarketMinder does NOT recommend individual securities; companies referenced herein are merely cited as examples of a broader theme we wish to highlight.

Here is a headline that may soon become endangered: "Big-Name Analyst Lowers Price Target for Widgets-R-Us, Cuts Rating to Sell." With new regulations coming down the pike and firms increasingly questioning whether these reports are worth the cost, banks and brokerage houses are starting to slash their armies of analysts. You might think this robs investors of informative analysis, but we wouldn't mourn the loss. While some genuinely good analysis makes the rounds now and then, a lot of it is marketing fluff, and very few reports are actionable for investors-even when the analysis is spot-on, markets usually discount them quickly.

The reports in question are what's known as "sell-side research"-research produced by financial firms that sell securities, as opposed to "buy side," which consists of investment managers, hedge funds and other outfits that put investors' money to work. Buy-side firms generally do research in-house and keep it close to the vest, lest they surrender a competitive edge. Sell-side reports, however, circulate far and wide, often for free-by design.

Why would anyone provide free knowledge? Well, even though they might not receive monetary payment, sell-side firms benefit plenty from their research circulating. This becomes clear when you identify sell-side research for what it is: marketing. Brokers use the reports to encourage retail clients to trade-for example, ditching Widgets-R-Us and buying WidgetMart instead, billing commissions in the process. Eyeball-catching reports generate media coverage, boosting visibility and improving search engine results. Favorable research can also help attract investment banking business from companies who need help with a merger, or issuing stock or bonds. Another consideration: A financial firm's institutional clients want access to corporate management teams-and positive reviews might make this easier to secure.

But times are changing. Research is expensive to produce, and asset managers are increasingly reluctant to pay banks to do it for them. One report estimates asset managers spend $15 billion annually purchasing sell-side research-an amount that may fall by a third in coming years. Banks and brokerage firms, meanwhile, are steadily finding high-priced analysts too costly to employ. As a result, sell-side firms are cutting analyst headcount. Plus, new EU rules (taking effect in 2018) will force asset managers to pay investment banks directly for research, ending the old model where brokerages could provide it to buy-side firms in exchange for custodying client accounts there and placing trades through them. While these regulations apply only in Europe, many investment firms operate internationally, likely creating some global spillover. We're guessing, "Yah, but we sent that report to MegaManager's American arm, not Frankfurt," won't fly with EU regulators.

If most sell-side research contained genuinely insightful, objective fundamental analysis, we might be inclined to shed a tear. However, an overwhelming body of evidence suggests this isn't so. Over 40,000 research reports are sent each week, and only about 6% of S&P 500 stocks get "Sell" or equivalent ratings. SEC rules require "that the views in the report accurately reflect [the analyst's] personal views," but opinions are squishy things, and incentives matter. If Widgets-R-Us needs an investment bank to handle a merger, who is it more likely to hire: The firm that issued happy "buy" ratings, or the one that screamed "sell!"? If Widgets-R-Us's management team is scheduling roundtable meetings with institutional investors, which firm has a better shot of getting invites for its institutional clients: The one with the glowing report or the scathing one?

While the above centers on company-specific analysis, the same principles often apply to research on industries, sectors and countries. Consider JP Morgan's recent dust-up with Indonesia, where the bank does billions of dollars in business each year by organizing Indonesia's bond sales. On November 13 of last year, JP Morgan analysts downgraded Indonesian stocks from overweight to underweight. On January 3, the government contested the downgrade and announced it would do no further business with the bank. Two weeks later, JP Morgan upgraded Indonesian stocks to "neutral," carefully noting that their research is "independent" and the result of "extensive and objective analysis." JP Morgan had an incentive to relent and did.^[i] Their experience reflects that of many banks operating globally, particularly in Asia, where government officials aren't shy about demanding positive reports or other measures to forestall capital outflows as a prerequisite to doing business.

All of this underscores the increasingly widespread opinion that sell-side research is mostly marketing. Now, that perhaps paints things in too-broad brushstrokes. We've read our fair share of insightful fundamental analysis from sell-side firms. There are varying levels of quality, and we suspect that in a more competitive environment, the cream will quickly rise to the top. The most thoughtful and useful research should find a market and stick around-particularly higher-level analysis, rather than company-specific stuff.

Still, investors shouldn't fret if sell-side research starts falling by the wayside-even the best, most insightful company-specific research reports are already priced into markets by the time you read them, diminishing any potential edge they might have provided. If anything, investors are arguably better off if the drip feed of individual stock price targets and "buy!" "sell!' "hold!" proclamations slows. Myopic analysis promotes myopic, short-term thinking-something long-term investors should avoid.