The Future of the Investment Research Industry

Six assumptions about the next five years. By Thomas S. White, president, Thomas White International

No industry has more upside potential than investment research. But to capture this potential, security analysts must focus on enhancing investor performance through insightful research and accurate stock recommendations.

Sadly, over recent decades, many analysts lost their moral compasses and became satisfied with producing promotional research. Too often, the research departments at investment banks foster an environment that discourages their analysts from making sell recommendations.

At the same time, the recent rapid globalization of capital markets is driving the worldwide need for improved business and investment research.

It is challenging, if not impossible, to predict precisely what our industry will look like five years from now. But it is possible to make several key assumptions.

For clients whose focus is on obtaining strong stock recommendations, performance considerations will continue to dominate their selection decisions. Institutional clients will always be interested in accurate earnings projections that are driven by exceptional business insight. As institutions are able to afford fewer sources, a superior earnings estimate performance record will become become even more important.

Traditionally, sell-side investment research reports included both business analysis and stock recommendations. While this practice will continue, expect to see an increasing divide between providers whose expertise is in making accurate buy/sell/hold recommendations and those whose strength is comprehensive business analysis or product knowledge.

Journalists who cover the mutual fund industry have long used widely available indices such as the S&P 500 to compare the performance of the investment managers. When covering research firms, however, reporters have had limited tools to evaluate the performance of research firms' recommendations.

The financial media will gravitate toward using a single measure for comparing recommendation performance. Retail investors will eventually become accustomed to using these publicly available comparisons and incorporate them into their own discussions and presentations.

Research consultants will request raw recommendation data from the provider and calculate the performance using their own methods. As in the asset management business today, each research provider will become known for its particular investment philosophy, research process and profile of its performance returns.

Continuous coverage of the client's stocks will become more important to institutions. Performance will still be the deciding factor, but only among the surviving pool of providers who are able to satisfy the particular needs of the client.

Over the next several years, advisors will stop using commissions for anything other than trade executions, thus ending the practice of using client funds to pay for research. This will be driven by fiduciaries as they respond to the new UK rules requiring the unbundling and full disclosure of previously hidden client costs. In mutual finds, ERISA plans and state funds, trustees will act to protect the interests of plan beneficiaries by ordering their money managers to restrict commission payment to trade executions.

This change will transform the research industry from a "cost center environment" to a traditional "profit center." This shift to a real world environment will mean that sales will be presented on a cost-benefit proposition for cash. Successful firms will be able to show that their research accuracy can boost managers' per form ance and thus the firm's revenues, while at the same time reducing expenses.

Without commissions from clients to pay for external research, and given the difficulty of raising management fees, asset managers will eliminate all but their most critical external research. Analysts' pleas to retain research will be based on classical cost-benefit arguments, with performance documentation an important factor.

The industry will level off at a size determined by a newly efficient market and will be traded in cash and priced by well-informed, cost-conscious institutions and broker-dealers. Superior research providers will want accurate, independent performance monitoring so as to better market their products. The result will be a textbook example of an efficient marketplace: transparent products priced in a competitive environment. This will foster a healthy, ethical research industry.

The leverage that accurate research has on subsequent capital returns is nothing short of breathtaking. Adhering to this belief will also allow the investment research industry to maintain its credibility and help professional security analysts validate their individual roles.