Since May Day 1975, when 180 years of fixed brokerage commissions ended on Wall Street, prognosticators have insisted that sell-side equity research’s days are numbered. From criticism of research paid for with soft dollars to former New York attorney general Eliot Spitzer’s campaign over conflicts of interest to threats from unbundling, passive investing and, this year, lurching markets and political and economic issues, doom-and-gloomers saw the relationship between sell-side research and buy-side investing as imperiled.
And yet, year after year, the sell side has proved surprisingly resilient. As Nicholas Rosato, head of North American research for J.P. Morgan, contends, for all the fears and fluctuations, what has not changed over the decades is the mutually beneficial relationship with the buy side. “The buy side,” says Rosato, “continues to need and value sell-side research.”
The 2016 All-America Research Team, Institutional Investor’s annual ranking of the U.S.’s best sell-side analysts, is now 45 years old; the magazine launched the ranking in 1972, three years before May Day. The longevity of the All-America Research Team is evidence of the ability of sell-side research to evolve, adjust and change. The team is the buy side’s judgment on the performance of its outsourced providers of investment analysis; it’s an election, not a stock-picking contest. What’s often overlooked — certainly by Spitzer — is how essential equity analysis, right or wrong, is to the health of the markets. Investment research is never omniscient or pure — neither, alas, are elections or markets — but the “buyers” understand that the depth and sophistication of the argument counts as much, or more, than the target price. In fact, this year proved to be a tough test — not a calamity like 2008, but challenging to both investors and sell-side research.
Rosato has good reason to be personally sanguine. While markets quake and geopolitics rumble, investors have once again elevated Rosato’s J.P. Morgan group to the top spot. The New York bank had held top honors for five consecutive years before Charlotte, North Carolina–based Bank of America Merrill Lynch edged ahead of it last year. This year J.P. Morgan leads with 40 analysts voted to the team — an improvement of four over 2015 — beating out BofA Merrill, which saw its total fall by six, to 32. In all, this year’s team includes 322 analysts from 30 firms.
BofA Merrill may have slipped in the team totals, but eight out of the top ten firms saw their numbers rise, notably New York–based Evercore ISI, from 25 to 30, and UBS, from 22 to 28. Those kind of increases at the top of the ranking were not the case in 2015; they may suggest that in a topsy-turvy year investors turned to the top firms, which tend to be larger and more diversified.
The weighted average presents a different picture, however. This measure gives greater credence to getting higher-ranked analysts voted onto the team; in that sense, it’s a quality-over-quantity measure. As it has for a number of years, J.P. Morgan runs away with the weighted average, in which a rating of 4 is assigned to each first-place position, 3 to each second-place spot, and so on. The bank racks up 109 points; the No. 2 shop, Evercore ISI, has 79. BofA Merrill slides to fourth place this year with a weighted average of 59.
There was some movement in the ranks by weighted average, appropriate to a volatile year. Evercore ISI rises from No. 3 in 2015 to No. 2, while UBS hops three spots from No. 6 to No. 3. However, four firms — UBS, BofA Merrill, Bernstein and Morgan Stanley (the latter two based in New York) — come out neck and neck, with only five points separating No. 3 UBS and No. 5 Morgan Stanley.
These results don’t begin to capture the crosscurrents of the 2016 investing scene, however. Any investment analysis is about calculating equity valuations that make sense in dynamic markets. That’s a tricky task late in the economic cycle. After a relatively calm and upbeat 2015, the S&P 500 started the year by plummeting in January and February, one of the worst starts in modern market history. One reason: fears that China, racked by its own stock market swoon and debt-burdened banks, was finally downshifting to lower growth, exacerbating a slump in commodities and energy. Then stocks roared back, wrong-footing many investors, at least until the June Brexit referendum in the U.K., where voters defied expert opinion and opted to leave the European Union. Markets plunged again, only to recover when it became apparent that the Brexit vote was not the end of the world, or even evidence that the U.K. was departing the EU any time soon.
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The rest of the summer settled into a mellow, relatively low-volume day at the beach. Then came September and markets dove again, anxious that low-interest-rate policies at the European Central Bank, the Federal Reserve and the Bank of Japan were failing and that their leaders, particularly in the U.S., were ready to raise rates or abandon quantitative easing programs.
Meanwhile, one of the most polarizing presidential contests in U.S. history has been unfolding, pitting real estate magnate and GOP nominee Donald Trump against the Democratic candidate, former secretary of State Hillary Clinton. Both drag around sizable negatives, and the race appears to be close. All elections create market uncertainties. It’s difficult to factor in exactly what effect the race is having on the markets, but it has created another layer of anxiety — particularly in the event of a blank-slate Trump victory — in an already nail-biting environment.
Although the S&P 500 was up 6.7 percent for the year in late September, the volatility has taken its toll, particularly on active investors, from large mutual fund complexes to hedge funds, many of which are underperforming. These are the sell side’s major clients. “It’s never easy when you’re dealing with clients who are losing,” says Brett Hodess, who runs BofA Merrill’s U.S. research effort.
Overall, many of the favorite stocks of 2015 fell from favor in 2016, in a market where many of the gains were coming from a narrowing universe of stocks. An active, value-oriented stock-picker’s market — the kind sell-side research has traditionally served — shifted to big-cap, dividend, share-buyback or defensive plays as the year unfolded. U.S. stock markets profited from investors globally seeking yield, but as BofA Merrill’s Hodess says, more than half of fund managers still believe the market is overvalued. David Adelman, director of Morgan Stanley’s equity research for the Americas, puts it another way. He sees a market that has swung from a focus on individual stocks to a fixation on macro factors: interest rates and geopolitics. “Analysts are experts at companies,” he says. “But the corporate component of the typical stock’s share price performance has declined. The contribution attributable to macro factors has grown.”
Ironically, that complex set of shifting factors has forced sell-side research to mobilize its strengths. “Brexit, the ECB, the Fed, the Bank of Japan, China — all have played into an approach of mixing macro research and stock research,” notes Vinayak Singh, the president of Evercore ISI. “That requires a tremendous amount of collaboration.”
The sell side at times has produced so-called thematic analysis — most notably in the late ’90s with the rise of the dot-coms — as opposed to the usual company-specific updates and reports. But this year these thematic analyses became ubiquitous. “This has been a year in which fundamental bottom-up stock picking didn’t always work out on a short-term basis,” admits BofA’s Hodess. “But there was a lot of demand for economic analysis and thematic work: What’s driving their industry? What’s disrupting them?” He cites reports from his group that require the participation of analysts from multiple sectors in far-flung locales, including deep dives into changing car technologies to looking at auto-parts providers as drivers of change to explaining why Pokémon Go is significant for the future of everything from smartphones to virtual reality games.
Other research directors are following that trend. Morgan Stanley’s Adelman also stresses collaboration, as well as cross-asset studies, an increasing use of big data and projects that link micro to macro.
At the very least, this kind of research throws up barriers of entry to smaller research shops lacking scale, reach and financial resources. Evercore’s Singh talks about talent migration to the bigger firms and consolidation of the sell side. The evidence for that may be in the greater concentration of ranked analysts among the top ten firms.
Still, no one on the sell side should get comfortable. This has been a low-volume, low-IPO, low-commission year, with passive strategies like exchange-traded funds (ETFs) continuing to attract inflows. As it has since 1975, the question of who will pay for sell-side research looms. In Europe a much-discussed regulatory policy known as Markets in Financial Instruments Directive II (MiFID II) mandates that research be unbundled from commissions, among many other changes — and it looks like it will finally be implemented on January 2018. The fact that MiFID II is an EU initiative doesn’t mean U.S. research is immune. The major firms have European clients and clients that do business on the Continent, and Hodess says they’re “concerned about complying with them [MiFID]. This change is coming.”
The effect? There’s some debate about that, but clearly true unbundling will encourage firms to support individual analysts over entire groups, or consolidate their business with some firms over others. “If you’re in a middle tier and you don’t have products of excellence, you could lose market share,” says Adelman. That’s slowly occurring anyway in the U.S., he adds, “as clients concentrate their research vote.” Others worry about commission dollars only going to already-established analysts — like All-America Research Team members — and making it difficult to nurture less visible up-and-comers.
The significance of passive investing also continues to be debated. To a degree, the passive phenomenon has cyclical elements; ETFs are less popular under different market conditions. But it’s also clear that low-fee ETFs are here to stay. Currently, says BofA Merrill’s Hodess, the sell side is precluded from offering research on ETFs because they’re technically considered an offering. But he believes that regulators may change this exclusion as they grow to become a larger part of the market — and an extension of sell-side research.
All these research directors emphasize their goal to be preeminent, or at least near the top — no one more so than J.P. Morgan’s Rosato, who acknowledges the complexities of sell-side research’s position but takes the long view, where consistent excellence, defined as serving clients’ increasingly complex needs, wins. His J.P. Morgan group has many advantages as part of a major, very profitable global bank with a top equity sales and trading operations. This allows him to focus on the ongoing relationship with buy-side clients.
What does he worry about? Evolutionary change in both regulation and the markets is pretty much a constant, he says. His biggest worry is keeping a talented group together, and that means training them well, managing transparently and providing them with the tools to work effectively.
So sell-side research has survived and even prospered — with one caveat. It’s fine that big, diversified firms can continue to provide the kind of sophisticated research the All-America Research Team rewards. But just as attorney general Spitzer’s attack on conflicts of interest produced, in the long run, sparser research on companies below the top tier — and, ironically, consolidation at the top — unbundling and passive investing could further widen the gap between the haves and the have-nots. And that may signal another kind of May Day.•
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