Why equity research fails over and over (and isn’t coming back)

Rupak Ghose is an adviser to fintech companies and a former financials research analyst.

When I joined Credit Suisse First Boston in the summer of 1999 I knew where the action was — equity research. Yes, really.

There was legendary telecoms analyst Jack Grubman at Salomon and Internet analysts Mary Meeker at Morgan Stanley and Henry Blodget at Merrill Lynch, each feted by the media and taking home tens of millions of dollars a year. They were the market gods, not the traders or the buyside. I was therefore thrilled to become a media equity research analyst at CSFB.

As the dotcom bubble was raging, the cowboys at CSFB went big on tech by hiring Frank Quattrone and his merry band. It was seen as a home run to hire such a huge revenue generator. CSFB gave Quattrone the autonomy he craved — including having the stock research analysts report into him.

Then things changed.

Two decades on from the Eliot Spitzer settlement that shook up the investment research business, there are four reasons why it is still shrivelling in size and credibility: declining information advantage, new competitors, margin pressure in secondary cash equities and a shrinking client base.

Let’s start with a declining information advantage. In the movie Wall Street, the corporate raider Gordon Gekko says: “Come on, tell me something I don’t know. It’s my birthday, pal, surprise me.” Bud Fox replies with insider information about a lawsuit at the airline where his father works. The RegFD disclosure requirements in 2000 started a push to prevent selective information dissemination by companies, and compliance on the sellside has been tightened significantly since then.

Management teams are more careful what they say, and access to them is more limited than back then. The declining influence of the sellside means the days of CFOs chasing analysts for their time are long gone. This creates an awkward competition between analysts to get into the good books of the companies they cover with softball questions and statements on conference calls like “Great quarter, guys!”

Downgrade a stock to ‘sell’ and the investment bankers may not be able to get you fired (at least not immediately), but you are likely to lose management access. That gets you to the same final destination of the dole queue, albeit more slowly than in the past.

That’s because these days a large part of the value proposition of analysts is taking groups of investors on roadshows to visit private and public companies, or access to their contact base of experts. But companies have been expanding their investor relations teams to take over management roadshows themselves, and in age of unbundled research, why spend a fortune on sellside research when you can just tap one of many expert networks?

However, technology, not regulation, is what has flattened the world of research. Sellside analysts — constantly being monitored by an army in compliance departments — are surprisingly poor at wading through the online noise to extract relevant signals on their stocks.

With so much information from companies, expert analysis and media content circulating free on social media, the bar that sellside content must clear to charge is much higher. The proliferation of blogs from both amateurs and experienced former sellside and buyside strategists at much lower price points is another deflationary drag on research spending.

As for the sellside’s continuous lack of negative ratings, dedicated short selling research firms such as Muddy Waters and Hindenburg have jumped into the breach. Some media outlets that are trying to protect their moats have expanded significantly in investigative journalism (an FT subscription to read Dan McCrum’s Wirecard reporting was far cheaper and valuable than the research reports the sellside produced).

Third is the evaporating profitability of sellside cash equities businesses. Most revenues and profits are generated by equity derivatives and prime brokerage. Cash equity commission rates have collapsed in equity trading, and market share ceded to high-frequency trading firms. Algos don’t need to speak to equity research analysts.

Fourth (and intertwined with all the above factors) is the increasingly small client base for sellside equity research.

Only a decade ago, large asset managers like Fidelity would be at the top of research client lists, generating huge amounts of revenues through trading commissions explicitly tied to research content. But the number of large, long-only asset managers that consume and pay for sellside content has collapsed, making analysts increasingly dependent on a small number of multi-strategy hedge funds.

The irony of all these developments is that equity research analysts now work more for investment banking than ever before. Although payments are now indirect and spread over many parts of the bank, the proportion of a cash equity sales and research department cost base that is covered by commissions from the buyside is lower than ever before.

And whatever happens on the regulatory front, it’s hard to see how anything will meaningfully change. The era of star analysts died years ago, and isn’t coming back.