What could save equity research? Part three
An analyst reflects on the decline of the sell side business model
Last week, I discussed why the live, analyst-to-investor conversation is invaluable. Nothing can replace the two-way exchange providing swift, dynamic information flow that speeds the investor toward making the call on a stock. Here are my final conclusions about the sell side business model.
3. Ratings and price targets should not exist
Year after year, at Avondale – where I used to work – our institutional sales force brought back fr om their clients a loud-and-clear mandate: ‘We pay for corporate access.’ Our revenue became heavily dependent on our ability to get executives of the companies we covered in front of investors – at conferences, in non-deal roadshows, at headquarters tours.
Pressure to provide corporate access conflicts with the sell-side tradition of providing stock ratings and price targets. An underperform rating makes it difficult for an analyst to have even a cursory relationship with an executive management team. Ratings are distorted by compromises analysts make to maintain relationships. Tell analysts their relationships are worth more than their ratings – and that’s what practically the whole buy side is saying – and the whole ratings game is thrown out of balance.
Further, the ratings structure inhibits an analyst’s ability to discuss a stock’s attractiveness in real time, reflecting current valuation (absolute and relative). Regulations shifted to the point where analysts were forbidden from saying anything that might conflict with previously published opinions. Stock prices change every day. Prices often are affected by quarter-end and seasonal influences that are temporary.
Analysts should be able to talk about their ideas from a real-time perspective. What’s my best idea today? How would I rank my names, in order of attractiveness? In order of fundamental qualities? What’s a range of possibilities – for earnings, for valuation?
All the staples of sell side research seem illogical to me – single-point price targets, based on static assumptions about potential earnings and valuation multiples. In my view, the custom of providing ratings and targets encourages this overly rigid approach to making recommendations.
It has been my side hobby, for a few years, to experiment with financial scenario models that do not result in single estimates of revenues and earnings. Instead of talking so much about estimates versus consensus, investors should fixate firstly on what range of long-term possibilities is implied in current valuation, secondly on what range of outcomes is probable, and thirdly does that mean the asset is mispriced?
We could have robust discussions about intrinsic and potential values of stocks, upside/downside scenarios, opportunities and risks – all the important decision points – without talking a moment about ratings and price targets. In truth, I had many discussions with investors that went just like that. Ratings and price targets inhibit the usefulness of sell-side research and should be eliminated.
Besides, virtually all rating systems are relative – based on a stock’s anticipated performance versus the broader stock market. No analyst creates a market wide forecast on which to base an individual stock rating. But the system implies we do, and that’s also wrong.
4. Independent equity research is likely to remain an unattractive business
With so many finance opportunities available in growing industries, the brain-drain out of equity research is likely to continue. We have yet to see fund flows out of active managers even begin to stabilize. If active assets under management (AUM) cannot grow, money managers will continue to reduce dollars spent on research.
Passive funds and ETFs continue to hold a tremendous marketing advantage. Active funds must achieve superb outperformance to compete. How many portfolio managers can meet that lofty standard? Wh ere will the active versus passive balance settle out? Will it be 40/60, 30/70?
At the recent rates of change, it would take quite a few more years for passive management to surpass 60 percent of AUM. With its market potential continuing to shrink, the equity research business is far from becoming a growth industry again. Good stock pickers are better off keeping their best ideas to themselves. I would have been.