Equity research is perhaps one of the most fulfilling professions. As an analyst, you get to study and value businesses with different business models and dynamic at that, to ‘grill’ CEOs who’ve spent more years running the business than you’ve been on the planet, serve some of the sharpest fund managers as clients and compete with a whole host of bright young analysts, all whilst enjoying the thrills of the stock market. However, equity research, especially sell-side research as an industry, has only seen dwindling economics over the years. Marc Rubenstein in this blog captures this evolution very well, especially given few people outside the industry understand the business model. It is not surprising though that they don’t understand as Marc brings out the biggest challenge of the business model – how do you price equity research. For some of us at Marcellus who spent the last two decades building sell-side franchises across two different geographies, the article is not just nostalgic but helps bring out the parallels to be drawn with a lot of new-age business models where the consumer doesn’t pay for the product or service in an obvious way and not everything can be paid for by advertising or data.
“…As a stand-alone product, equity research is very difficult to value. It’s hard to keep private, so clients are reluctant to pay for it. And the range of values they assign to it can be huge. As an investor later in my career, I would read a lot of guff, but occasionally I would read research of tremendous value which directly contributed to millions of dollars of investment performance (although knowing which was which ex ante is a challenge).”
This challenge meant that equity research was often bundled free with trading commissions (brokerage)
“Bundling works best when two conditions are met: high variance in demand and zero marginal cost. The first makes the product difficult to price on a stand-alone basis; the second ensures it’s never sold at less than cost. If a product costs $100 to produce but the market only values it at $50, profit can be maximised simply by discontinuing it; if it costs $0 to produce then some value can be captured including it as part of a bundle. Equity research, like many information goods, fulfils both these conditions.
The problem is that the value of equity research and the value of trade execution ultimately flow to different parties. Although institutional investors notionally pay for both, the bundled fee comes out of the fund value, so the cost is borne by end-investors. End-investors typically pay fund managers a fee of 0.50%, say, for their services and cover the costs of trade execution out of their fund value. While there’s no doubt that they benefit directly from trade execution, it is moot whether they derive benefit from the equity research—that benefit stays with the investment manager. Consequently there’s an argument that investment managers should pay for it directly, out of their 0.50%. Indeed, because they’re not paying for it directly, investment managers may tend towards overconsumption of research. Valuing equity research means solving a principal-agent problem buried inside a bundling problem.”
Regulations although well intended haven’t particularly helped either:
“…To address this issue European regulators came along in 2018 and unveiled MiFID II—the second Markets in Financial Instruments Directive. The directive sought to unbundle equity research from trade execution. Investment managers and brokers are required to establish separate fee schedules for trade execution and research, with investment managers paying for research either out of their own P&L or else via an explicit charge to their end-investors.
The rules have been in place for two and a half years now. During that time, research budgets have been slashed, confirming that equity research was probably over-consumed in the first place. Some estimates suggest that investment managers’ research budgets have fallen by an average of 30% following the introduction of MiFID II. Many analysts have left the industry.”
But equity research does play an important role in price discovery and the challenges have meant that quality of research has improved and new business models are emerging:
“… the public role that equity research plays in keeping companies in check. It benefits everyone with an interest in functioning markets that scores of analysts are engaged in the scrutiny of company financial statements; and crucially that they are not paid to do it by the companies themselves. Newspapers do it in politics; equity research does it in business.
If there’s one silver lining from the process, it’s that research quality has improved. It’s difficult to measure quality but several studies concur. Fighting over limited available resources from investment managers, research analysts compete more directly in the quality domain. Even if MiFID II is unwound, the forced process of attaching a value to research should leave this dynamic intact. This is a good development for smaller and even solo research operators who were never able to compete on quantity. With technology solutions emerging to meet their distribution needs, they have capacity to create strong franchises.”
“…As a stand-alone product, equity research is very difficult to value. It’s hard to keep private, so clients are reluctant to pay for it. And the range of values they assign to it can be huge. As an investor later in my career, I would read a lot of guff, but occasionally I would read research of tremendous value which directly contributed to millions of dollars of investment performance (although knowing which was which ex ante is a challenge).”
This challenge meant that equity research was often bundled free with trading commissions (brokerage)
“Bundling works best when two conditions are met: high variance in demand and zero marginal cost. The first makes the product difficult to price on a stand-alone basis; the second ensures it’s never sold at less than cost. If a product costs $100 to produce but the market only values it at $50, profit can be maximised simply by discontinuing it; if it costs $0 to produce then some value can be captured including it as part of a bundle. Equity research, like many information goods, fulfils both these conditions.
The problem is that the value of equity research and the value of trade execution ultimately flow to different parties. Although institutional investors notionally pay for both, the bundled fee comes out of the fund value, so the cost is borne by end-investors. End-investors typically pay fund managers a fee of 0.50%, say, for their services and cover the costs of trade execution out of their fund value. While there’s no doubt that they benefit directly from trade execution, it is moot whether they derive benefit from the equity research—that benefit stays with the investment manager. Consequently there’s an argument that investment managers should pay for it directly, out of their 0.50%. Indeed, because they’re not paying for it directly, investment managers may tend towards overconsumption of research. Valuing equity research means solving a principal-agent problem buried inside a bundling problem.”
Regulations although well intended haven’t particularly helped either:
“…To address this issue European regulators came along in 2018 and unveiled MiFID II—the second Markets in Financial Instruments Directive. The directive sought to unbundle equity research from trade execution. Investment managers and brokers are required to establish separate fee schedules for trade execution and research, with investment managers paying for research either out of their own P&L or else via an explicit charge to their end-investors.
The rules have been in place for two and a half years now. During that time, research budgets have been slashed, confirming that equity research was probably over-consumed in the first place. Some estimates suggest that investment managers’ research budgets have fallen by an average of 30% following the introduction of MiFID II. Many analysts have left the industry.”
But equity research does play an important role in price discovery and the challenges have meant that quality of research has improved and new business models are emerging:
“… the public role that equity research plays in keeping companies in check. It benefits everyone with an interest in functioning markets that scores of analysts are engaged in the scrutiny of company financial statements; and crucially that they are not paid to do it by the companies themselves. Newspapers do it in politics; equity research does it in business.
If there’s one silver lining from the process, it’s that research quality has improved. It’s difficult to measure quality but several studies concur. Fighting over limited available resources from investment managers, research analysts compete more directly in the quality domain. Even if MiFID II is unwound, the forced process of attaching a value to research should leave this dynamic intact. This is a good development for smaller and even solo research operators who were never able to compete on quantity. With technology solutions emerging to meet their distribution needs, they have capacity to create strong franchises.”
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Note: the above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India as a provider of Portfolio Management Services. Marcellus Investment Managers is also regulated in the United States as an Investment Advisor.
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