WSJ is wrong about the future of investment research

Very interesting article yesterday at the Wall Street Journal.  Entitled, “Stock-Research Reform to Die“, the article describes what’s happened in the wake of Eliot Spitzer’s landmark settlement against Wall Street brokers in 2003.

According to the WSJ, this settlement was part of a wider Wall Street wrist-slap against ingrained culture that issued “overly optimistic stock research in order to win investment banking business.”

One of the results of the settlement required major brokerage houses to spend $460+ million on independent stock research for their clients.

The WSJ’s conclusion: six years later and almost no clients are using independent research.

At Credit Suisse, which has mostly institutional clients, the number of times retail clients accessed independent research from the firm’s Web site ranged from 16 during the third year of the settlement to 110 the first year.

At the old Salomon Smith Barney — now part of Morgan Stanley’s Morgan Stanley Smith Barney — its roughly 4 million retail households accessed about 12,000 reports each month. Less than 2% of Goldman Sachs Group Inc.’s Private Wealth Management clients likely downloaded a report each month, according to data from the public reports.

The WSJ mentions 3 reasons why investors haven’t taken up independent research at their broker:

1. investors rely upon their brokers to act as a screen:  While 11% of brokers consumed independent research at least occasionally, they typically don’t send independent research out to clients.
2. investors don’t rely as heavily on stock research today as they used to: “In the late 1990s, a positive report from a hot analyst could send a stock soaring. That effect is more muted today.”
3. structural changes away from brokers to advisors: Commission-based business is old-school.  It’s been replaced by fee-based professionals acting as advisors.  There is less emphasis on trading at the retail level and less need for this type of research.  Combined with chinese walls going up between brokerage and investment banking, banks are cutting back on research teams as research becomes harder to monetize without the tie-in with banking.

Just wanted to chime in with a couple of comments:

• I agree that full-service brokerage clients rely upon their brokers to act as screens.  That’s why they pay them and why they work with an advisor.  The vast majority of clients do not know how to read research or want to be bothered.  They want a quick synopsis why they should own a particular stock and for that, the broker acts as a type of well-heeled Cliffs Notes.
• Maybe investors weren’t even aware that independent research was an option?  Do they know why it’s important?  Are investors aware of the biases which still exist in sell-side research?
• Why depend on the guilt party to distribute the cure to the sickness?  That’s nuts.
• Totally disagree with the fact that investors don’t rely on research. I would say that it’s more accurate to say that given historical conflicts of interests, investors no longer trust institutional research.  Given the gaping void left by Wall Street and the rise of financial bloggers and aggregation sites like SeekingAlpha,  many investors are actually consuming more research on more companies than ever.  We’re in a Renaissance/Gold Run/Bull Market for investment content — it’s institutional research that’s not finding its footing.
• It’s hard for brokers today. Without an edge in research or asymmetrical information, it’s hard to push stocks and get paid for it.  That’s why many brokers have become mere wolves-in-sheeps-clothing: they’re still brokers but get paid as advisors.  We’re also seeing the emergence of true financial fiduciaries who work extremely hard for their fees and performance for clients, in up and down markets.   These advisors are doing real research or hiring people who do and they’re the ones consuming the research, not clients.
• I think we’re seeing the investment field changing so quickly before our eyes.  On one hand, we’re seeing investors go boutique and sign up with independent financial advisors.  This is like more full-service than full-service.  On the other hand, we’re seeing investors retake the reins of their portfolios and managing things on their own — classic DIY investing online.  There is also a middle ground of investors who want more control but also want professional advice to support them along the way.  Regardless of the model, someone is consuming research, whether it’s the client or the advisor.
• We need new business models to foster more independent research to fill the gap left by Wall St.’s void.  Tools to rate accuracy and trust-worthiness.  Performance.  From individual positions in a portfolio to the dynamics of portfolio management in general.

Interesting to see that most of the firms polled in the WSJ article were not planning on continuing distributing independent research.  Some have jettisoned research while others are bolstering their efforts.  That still leaves a tremendous opportunity out there for anyone who can provide actionable advice to the majority of investors out there.

Additional Resources

• Subscribe to receive free daily updates from NewRulesofInvesting.
• Follow me on Twitter
• WSJ’s Stock-Research Reform to Die
• SEC: landmark settlement against Wall Street brokers in 2003
• E*Trade further blurring the lines between full-service brokerage and DIY investing
• How investing is changing before our eyes

Morgan Smith Barney Stanley and more on investment research

It appears as if Smith Barney is preparing to leave the Citigroup umbrella and join Morgan Stanley as troubled Citigroup looks to unload assets and raise capital.  Over 9 million investment accounts and over $1 trillion in assets look ready to join Morgan’s extensive brokerage operations.  As more and more consolidation occurs in the investment research community, there is going to be a gaping void felt by retail investors worldwide.

Morgan Stanley's CEO John Mack

Historically, investment banks were the engines of equity research.  Research worked for investment banks even though the research was given away freely to account holders.  Investment banks were essential in demand creation for equities and research paid for itself many times over via investment banking fees from the issuing companies.  With investment banks clinging to one another for dear life in order to shore up their own balance sheets, the research industry is undergoing a sea-change.

I’ve spoken previously about the opportunity for New Rules type companies to step in and fill the void.  Expert communities, crowd sourcing and piggyback investing will all continue to gain prominence in the investing ecosystem in years to come.  IR firms who “get it” will play a valuable role for investors and firms trying to get their story out.

As the research game field changes, Roger Ehrenberg thinks the name of the game is disaggregation and specialization:

The difference between how it used to work and how it will work in the future is the disaggregation of Equity Research. The major securities houses will have global distribution platforms for connecting issuers and investors, and to provide markets on a worldwide basis. There will be relatively few of these players as the cost of maintaining a global distribution platform is huge and, in my opinion, a natural oligopoly. But research will be “open sourced,” as the charade sometimes called “Wall Street single-stock research” is finally exposed.

Having the securities underwriter issue a “puff piece” as part of the IPO selling process is a waste of time, money and is fraught with conflicts. The Global Settlement was just that – a settlement. It wasn’t a solution. There only reason for bulge bracket firms to pay for costly research operations is if they help Investment Banking land deals. Bulge bracket research budgets in the early 2000s were in the $500 million to $1 billion+ range. If one were to disaggregate commissions into payment for research and execution, it is safe to say that investors attributed little value to Wall Street research. So how did the gap get filled? Investment banking mandates, together with outsized commissions on “hot” IPO deals that precipitated the Global Settlement in the first place. Transparency will enter the research venue, where investors buy research from the best providers at a known cost. There is no reason why a securities dealer should have better research than anyone else, and given that this is not their area of specialization it isn’t clear that they should be in this business at all. Added complexity is almost always a bad thing, and securities dealers have enough to manage without operating a separate research arm.

It’s time for some black swan contingency planning

As first appeared on the American Express OPEN Forum Blog:

I believe I have an interesting take on the current financial imbroglio we find ourselves in.  I am both a small business owner and a financial adviser.  So, while the stock market has taken a significant whacking including the largest American bank (WaMu), insurance firm (AIG) and broker (Merrill Lynch) all having tanked, I am feeling the fallout from the current malaise two-fold.  This blog post is based on my insights into helping a small financial advisory make it through the tough slog ahead but applies to any business.

Black Swan Contingency Planning

What’s the issue: There is an incredible amount of interdependency we’re witnessing across businesses, sectors and geographies.  When a mortgage bank fails in the US, it has far-reaching consequences felt around the world.  Little events are exacerbated and seemingly discrete events domino into global markets tanking.  While banks like Merrill and Morgan looked as if they should weather this storm OK (albeit with some lumps), Lehman’s demise called into question these firms’ viability overnight.

What to do:

1. Always have a “what if everything goes wrong” Black Swan contingency plan: I’m not talking about preparing for a nuclear war or a situation where all money loses its value — if that occurs, quit your business, hock everything and buy some ammo and head to the hills.  I’m talking about that Black Swan type event that could impact your business so acutely that your business may not be the same for years in its wake. Financial partners have their funding means dry up.  Customers push out purchasing decisions indefinitely.  Distribution channels close.  In fact, small businesses are much more nimble than large firms in dealing with these types of changes but lack the staying power that comes from being a larger company.
2. Is”safe” really safe?: During a black swan type event, things go wrong that we didn’t expect.  Is your banking partner really solid?  Ask him.  What if one of your trading partners goes under?  Can you continue buying/selling?  In my business, core money market accounts are what clients use to park their money.  We’ve read of a few of these types of fund cratering.  What’s going with in your firm’s products?
3. Backup everything that can be backed up
4. You can’t be too conservative: Taking risks isn’t going to be rewarded in the short term.  Cash is king in this market and it will pay to preserve your business capital and business processes so that you can take advantage of the situation when the markets rebound.

Assessing Partner Viability

What’s the issue: Partner demise can not only create a drag on your business, it can tank it.  We’ve read various reports surfacing that JPMorgan played a role in Lehman’s demise.  JPMorgan financed Lehman’s daily brokerage business and by freezing Lehman’s account, it looks like Lehman may have entered a death spiral.  The point here is that given our various integrated relationships, it’s important to look at everything, from accountant to lawyer to bank to hosted CRM platform and test how dependent we are on our partners.

What to do:

1. Think Global, Act Local: Watching Lehman Brothers’ quick demise and its subsequent spillover to firms like Merrill Lynch and Morgan Stanley, it’s clear that what we’re dealing with is systemic. What may have begun as poor risk management of singular firms has become everyone’s problem given the financial communities various webs of interaction and influence.  Instead of my clients asking “Hey, how’s my portfolio doing?” (they know NOT to ask), they are asking fundamental questions like “Are banks going to make me whole on my CDs?” and “Are my cash and securities safe if you or your financial custodian go under?”  I’ve spent so much time on the FDIC’s website (a branch of the U.S. government called the Federal Deposit Insurance Corporation), that I’m thinking of making it my homepage. After the Depression, the federal government instituted a program to insure bank accounts up to $100k (this has been temporarily expanded to $250k in some cases) to support banks and help protect from future runs on banks.

I send clients here for a treasure-trove of information like a list of failed banks, what protection consumers really have,  and what role the government is playing in bailouts of such massive banks like WaMu.  What was taken for granted in times of plenty is being called into question.  To extrapolate this further, times of crisis require talking to your trading partners and determining their solvency and their ability to weather the financial storm.  If suspect, changes need to be made to protect your business and your customer base.

Bolster customer relations

What’s the issue: During chaotic times, customers frequently feel left out in the cold.  Frequently, in the asset management business, it’s not their poor performance that creates customer dissatisfaction but rather how well they are treated by their adviser throughout this process.  Customers understand that there are issues beyond the control of the service provider.  What they really demand, though, is the guidance of the service provider during tough times.  Here is an interesting article about customer churn during tumultuous times in the asset management industry.

What to do:

1. Be proactive about working with customers/clients though the crisis: This is extremely germane to the financial advisory business.  While many clients may not actually need to make changes to their portfolios, what clients frequently want to know is that their supplier/service provider is emotionally supportive throughout the crisis.
2. Call clients: Don’t rely on form letter communication.  Get on the phone and listen.  This simple rule is worth money.
3. Go out of your way to connect: This works with clients and prospects.  Plan mini-seminars to discuss what’s going on.  People have a lot of questions — become the go-to-guy in your field during times of trouble.

Summary

Crazy times call for crazy measures and require shoring up every aspect of your business.  From customers to suppliers, small business owners must secure distribution and supply lines.  While taking risks should be minimized, by doing good diligence, business owners should not only secure their current business but position themselves for increased business flows when things snap back.  They always do.

Read more about the issues web workers are dealing with and how to cope with an always-on, always wired existence.