Investment Research: The Past, Present, and Future

In this episode of Rational Markets, we offer a comprehensive exploration of the investment research landscape, highlighting its key players and underlying motives while addressing the disconnect between intent and execution.

Drawing from Darrel's experience in a boutique investment research firm focused on the energy sector, we demystify how analysts track fundamentals and market events to shape their stock recommendations.

We scrutinize the format and substance of typical investment research reports, which often inundate readers with dense tables and jargon, yet often lack meaningful insights. We raise questions about the effectiveness of sell-side recommendations, especially when considering the underlying revenue drivers of banks.

Additionally, we discuss the impact of downsized research teams and the resulting coverage gaps in essential industries. Despite these issues, we remain optimistic about the growing need for independent research and the potential for innovation as barriers to accessing quality insights diminish. Join us as we delve into these complex financial topics in future episodes.

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Transcript

0:18

Okay, welcome back to Rational Markets. So the goal of today's episode is to provide an overview of the world of investment research. We'll talk about who the key players are, what the stated versus actual purpose of investment research is, as well as some of the incentives driving it that I think you should be aware of as an investor. So this is a field that I know quite well because I spent most of my career in it, But I understand that investment research isn't really a topic that's widely understood beyond the sort of inner circles of finance. It can be really quite esoteric. And even if you do have a general understanding of the industry, there's a lot of nuance that most people would never be exposed to if they'd never worked as an analyst. While I think that investment research is as important as ever, it's also failed to deliver in a lot of key ways. And as a result, the industry has really atrophied and really hasn't lived up to its promise. And so my hope is that by the end of this episode, you'll have a better understanding of investment research, which I think will then help you be better equipped to read research reports and think critically about the financial media you consume as well. So what is investment research? The idea of investment research is actually quite straightforward and intuitive, but in practice, it's actually riddled with conflicts of interest that makes things a lot more muddy. But basically, investment research is where an analyst who's typically employed by an investment bank will give investment recommendations on certain stocks or sectors. So they'll basically write reports, they'll talk to clients and give them sort of advice, so to speak. So for example, I worked at a boutique investment research shop covering U.S. Energy companies, and my firm was a little bit different than other research providers in that we weren't a bank, but I'll return to why that's an important distinction later on. But my job as an analyst was really to cover a set of companies. In my case, I covered upstream energy companies operating primarily in the Permian Basin, which is even to this day a very large oil and gas field in the U.S. But in its heyday, there were dozens of publicly traded companies operating in the Permian, which meant that I had to be up to speed on all of them. And so that's what it really means to cover a company or cover a sector. It means to really understand the fundamentals of it. And we discussed the concept of fundamentals in an earlier episode called The Psychology of Investing. So watch that if you want more detail. But basically, analysts need to understand what drives value in the companies and industries that they cover. So what sort of news or events causes the stocks to go up versus down? What makes one company stronger or weaker compared to another? What are the risks and opportunities the catalysts facing these companies? And ideally, a good analyst will also be a subject matter expert. So they'll know their sector extremely well, whether that's semiconductors, energy, retail, etc. And ideally, they'll also have data to back up their views. And so here are some examples of what investment research reports actually look like. So you can see that they tend to have a lot of charts, a lot of tables, but frankly, a lot of them are quite an eyesore, if I'm being honest. They're full of these really dense tables and often filled with industry jargon. And they're designed to look really authoritative. But often, I think that really just hides a lack of conviction because oftentimes, as many tables and numbers and charts as these reports have, often they really don't have anything substantial to say. But ultimately, the goal of these reports is usually to summarize an event. So for example, an analyst may have recently met with the company management, they may have gone on a tour with them on site, there might have been a quarterly earnings release. So oftentimes the reports will summarize those events and sometimes the analyst will stamp their reports with an investment recommendation on that specific company which in the world of sell-side research is either a buy rating a sell rating or hold rating which is pretty self-explanatory but basically tells you whether the the analyst is positive on the company whether they they recommend that you buy the stock or sell it or hold it. And the idea is that the investors, the bank's clients will read these reports and they'll be able to have calls or meetings with the analyst to ask further questions and dig in deeper to the content. And so why is this field needed? You might think that, you know, large investors like, for example, large pension funds, like in Canada, we have the Canadian pension plan. These are really large, sophisticated institutions with a lot of money, quite frankly. So why can't they do this themselves? Well, these same institutional investors will often have hundreds or even thousands of companies that they invest in. And so as, you know, sophisticated and large and well funded as they are, they generally still need to lean on third parties like consultants or the sell side analysts to help them make good or at least informed investment decisions. So that's the overall concept of investment research. But at this point, we really need to zoom out and talk about the key players in this industry. I think most of you have heard by now the terms buy side and sell side. And they sound like really fancy terms, but really they just boil down to in any market, there are buyers and there are sellers. And in the capital markets, the buy side are the ones buying financial securities. So think stocks, bonds, there are more complicated financial instruments like options and swaps. So basically, they're really big investors. They own a lot of shares in companies. They often lend out money as well in the form of debt to companies. And the company will then take this funding to invest in their own businesses, whether that's building factories, building new products, hiring staff, etc. And so you might think, well, I own stocks. Does that mean I'm on the buy side? Well, in a way, yes, but buy side generally refers to large institutions that manage large sums of money for their clients. So think billions or sometimes even trillions of dollars like those pension funds that I talked about. So really, the buy side can really be further broken down into institutional investors and retail investors. So a hedge fund or a pension fund are examples of institutional investors. Whereas where when an individual like yourself or myself when we open a brokerage account at a bank and buy stocks on our own behalf we're considered part of the retail market which brings us to the other side of the market the sell side these are the firms that basically serve as a middleman between the companies who want to raise capital to fund their businesses and the institutional investors who have the capital to invest. They'll also help their corporate clients with M&A or mergers and acquisitions, which is where companies either sell off parts of themselves to raise capital or maybe try to streamline their operations, or they'll try to combine with other companies for strategic or financial purposes. And so these sell-side entities, they're typically banks, but specifically investment banks. So these are not the types of banks that you and I walk into to cash a check, although sometimes those big banks do also have investment banking departments. But most individuals don't interact with investment banks really ever. So when a public company is looking for funding, they'll typically hire an investment bank to help them find investors. The investment bank has a team of bankers who will basically create these fancy PowerPoint slides called pitch books or pitch decks, which detail the company's financials. They'll talk about the company's opportunities, risks. And the goal of these pitch decks is to help potential investors get comfortable enough with the company to invest or provide capital. And these banks also tend to have trading departments which are again a type of intermediary or middleman they basically facilitate trades in stocks bonds and other securities between their buy side clients and investment banks also tend to have so-called equity research groups however banks have been slowly reducing headcount in these groups so on that point why have banks become less focused on research? Well, to answer that, we need to really understand how investment banks make money in the first place. For banks, there's a bit of this silent understanding or kind of hidden truth that is really the investment banking part of the business that drives your revenue. And those research reports that you saw earlier, they're actually freely available to the bank's clients. And this is why equity research is often called a loss leader because research itself actually doesn't drive much revenue at all for the banks. Instead, research has three primary functions for banks. The first is to drive banking mandates. So when a bank or an analyst adds a company to its coverage list, is effectively giving that company exposure, particularly to the bank's clients, and it's essentially a form of advertising. Legally speaking, the research and banking departments are separated by informational walls. They're also called Chinese walls. But this basically means that banks and analysts at a bank are not supposed to communicate or interact with one another. And in theory, this prevents any sort of conflicts of interest because they'll be working independently. They won't know any sort of non-public information about each other's activities. But in my experience, this is really just a formality because a research analyst at a bank knows full well the bank's list of clients. They'll know which companies the bank is trying to do business with or trying to pursue. And this is why sell-side analysts so rarely issue sell targets. So those buy, sell, hold ratings I talked about, they almost never say anything negative about the companies that they cover because sell ratings are just bad for business. If you think about it, there's really no economic incentive for most analysts to say anything critical about the companies that they cover, particularly if they work for a bank. Quite the opposite. The more optimistic the analysts are, the more business that tends to drum up, particularly again, if they work for a bank. And the second purpose is corporate access. So what does that mean? Banks, again, tend to serve as a bit of a matchmaker between investors and companies. Since sell-side analysts tend to have strong relationships with CEOs and members of the leadership team, they'll often host meetings and events that connect management team members with bite-side clients. These networking events are called corporate access, which is a service that BuySide pays for. The last purpose of equity research for banks is to drive trading volume. So again, most banks have trading desks and the purpose of these trading desks is to make money by buying and selling shares on behalf of their clients. So when an analyst who works at a bank publishes research on a company, that bank's trading desk will then go out and call its list of clients that trade that stock or are involved in that sector and they'll pitch the stock. They'll basically regurgitate the content of the research report and the traders and the analysts on the buy side might then go and trade that stock and they'll send that order to the bank. And this basically drives trading volume to the bank, which the bank then captures a spread or a profit on. Those are the three primary masters that research serves. And you'll probably notice that none of those masters are the individual investor or the investor community in general. And in my view, that's ultimately why investment research has had such a fall from grace over the past decade. Combined with increased regulatory scrutiny, the result is that investment research has really been facing two major issues. The first of which is brain drain. With fewer job opportunities at banks, analysts have basically fled the sell side in droves, and some of these analysts have ended up working for the same companies that they used to cover. And the second issue is what I'll call the coverage gap. There's been this major underlying trend in financial markets, which is that they become increasingly concentrated. As you can see here, in 2010, the top five companies made up 19% of the index, whereas today they represent about 35% of the index. As a result, banks don't want to spend a lot of time or hire an army of analysts to cover every industry within the economy. Instead, they might just have one analyst that covers the entire energy sector, which could span from oil and gas to renewables to mining, etc., They might have another analyst that covers the entire kind of retail sector. And they'll really just focus the bulk of its effort and the bulk of its staff on the biggest, most liquid tech stocks like Microsoft, Google, NVIDIA, etc. And so the sell-side business model has clearly made it really difficult to provide truly unbiased research to investors. It's worth mentioning that there are other research shops out there that charge clients specifically and explicitly for research. So those companies tend to have fewer of these kind of underlying motives. The company that I worked at for a decade, for example, had this business model. And this does eliminate that inherent conflict of interest I talked about earlier. And it does allow analysts to more freely talk about the companies and the sectors that they cover without the fear of damaging corporate relationships or angering their employer. But even firms like this have struggled due to a challenging regulatory environment facing research and just general kind of skepticism towards the value of research. So to recap, instead of being focused on providing objective, investable insights for clients, the equity research industry has really been incentivized to instead act as a glorified marketing agency for companies. What we've seen is analysts writing positive research simply to please corporate clients and to drum up banking mandates. They often just regurgitate news and sound bites that they get from management and really just focusing on the short term as opposed to long-term value creation. And with a poor track record of actually delivering high-quality investable insights, clients just stopped paying. And this has led to a massive exodus of talent, particularly analysts that cover industries in-depth beyond the tech sector. And all of these things combined with the rise of passive or ETF investing, there's just fewer and fewer experienced eyes following a lot of companies in the economy, particularly outside of the tech sector. And the result is what I'll call a research desert. There is an absolute dearth of experienced analysts who know industries and know companies covering these areas, making sure that the price tags actually match the value. And this is particularly true in unloved sectors like energy or other real assets. As an example, there are over 50 analysts covering NVIDIA, while there are only five covering ARK resources, which is one of the largest oil and natural gas producers in Canada. And these companies with real assets are now seeing a resurgence in interest as sectors like software are starting to see real challenges. And I'm aware that a lot of this sounds quite gloomy for investors, but I'm actually quite optimistic because while the traditional model of investment research has led to a lot of banks pulling back from it, I actually think this is a massive opportunity because the need for high quality independent research is greater now than ever before, precisely because the old model of research was so broken. So I hope that now you have a better understanding of the mechanics and the incentives driving investment research and that you have a more informed view of what you see in the media. So stay tuned as we break down more complex and nuanced topics like this in finance and you can access industry and company deep dives on our sub stack the link is below and as always thanks for watching.