Trust and brand matters more than funding model for research

Where will commissioned research go after the EU's MiFID II regulation? What can listed companies do to stimulate interest in their shares?

We interview Neil Shah, Director of Research at independent investment research provider Edison, on the coming of age for the commissioned research service, how the EU’s MiFID II regulation will affect asset management and equity businesses, and what listed companies can do to stimulate interest in their shares and to help ensure they get a fair and fundamentally based valuation.

Headquartered in London, Edison was founded in 2003, follows 700 stocks globally, has 420 corporate clients and 110 staff. Its research is read by investors in 218 countries.

Could you briefly describe Edison Investment Research’s business – what services do you offer, to whom, and in which markets?

The way we build our services has always been in response to customer demand, and so Edison has evolved over time. We started out as an independent research company, meaning independent from traditional conflicts of interest in banking. Companies pay us to write research. Initially we thought it would be a UK business, producing regular, good-quality research on behalf of small and mid-cap companies, and that our sweet spot would be under-covered listed companies – those which few or no equity analysts follow.

Before joining Edison I spent some time on the buy side, in asset management. I was amazed that when you tried to find research, even on medium-sized companies, you often had to go back five years or more to find the last published detailed note on the company.

When we started out 15 years ago, the value proposition was rather simple, and it still is: a company which subscribes to our research coverage will get an initiation note and then continuous quarterly updates every year. It is meant to be a comprehensive coverage, so if you have a very active company, you get more regular updates. The second part of our value proposition is to make sure that the research is widely distributed. We spend a lot of time building a very broad database, from which we can distribute our research content free to view on Bloomberg and all the other electronic libraries, so you don’t need any special access to find the information if you are a professional investor. Also, we have built our own e-mail database. Over the last decade, we have spent a lot of time developing our website and social media channels as well.

What customers get from us is effectively a heat map of who has consumed the research content. So, having started off as a commissioned research business for listed corporates, the next thing our customers asked us was to help them meet all the investors that are reached via our research. Hence, we started a roadshow business as well. We take companies on the road across Europe, North America and Australasia to meet different tiers of investors, from institutional investors to retail, family offices and private wealth management.

The newest part of our business originated just before the global financial crisis of 2008-09, when some of our clients started asking us to do due diligence work for them. They were increasingly fed up with what they perceived was almost a box-ticking exercise they were getting from traditional service providers, so they asked our analysts to do it for them instead. Then, if there was a deal to be done, I would bring our analyst on site to go talk to the acquisition target’s management team and look at the numbers. What the companies would then get from us was a slightly more opinionated due diligence or transaction report, which they appreciated much more.

So today there are three legs to the business:

  • Edison Investment Research, which is the market-facing investment research
  • Edison Advisors, which includes the investor relations road show business
  • Consulting

Our business has been growing on the research side over a longer period of time, and there is also a lot of new regulation, which has led to a tailwind around this for us. The investor relations business is complementary to our research, so there we are growing with our existing customer base. The consulting business is more ad-hoc and project-based.

Edison was founded in 2003, before the global financial crisis and the avalanche of new regulation of the financial services industry in its aftermath. What opportunities did the founders see at that time, and what where the demand drivers for the offering you launched?

Fraser Thorne, one of the co-founders, used to work at Newton Investment Management, and always wanted to understand the motive as to why he was getting research from sell-side players, and it was not particularly transparent. When he decided to leave Newton, his idea was to set up an independent research firm with a very clean model, funded by corporate issuers. He wanted investor customers to know what they get and why, and to have a very transparent pricing mechanism around it.

My motive for getting involved with Edison was slightly different. I learned during my previous employment as an equity analyst at Goldman Sachs that research evolves, and even if the end product might look the same, the underlying business model will change. Most would argue that the securities industry led itself to disrepute, culminating in the conflict of interest problems with poorly performing IPOs after the dotcom bubble burst in 2000-01. I am a firm believer that good quality research makes a difference. It will be read by investors and advisers and means shares are more likely to be properly priced, reflecting the true value of a company.

I met Fraser and liked the idea that it was an alternative funding model, understood that there was a conflict of interest issue being addressed, and spent some time talking to former heads of research at Goldman Sachs about the model. I think that the penny-dropping moment for me was when I realised that research is a brand game. As long as you can establish a process and build trust around your product, regardless of what sort of funding model you have, you will make it work. Initially everyone thought we were mad: “How can anyone believe what you are writing, if the company itself is paying for it?” But research is produced for many reasons, and not all of them are very transparent. After nearly 15 years, I think we at Edison have won that argument, as evidenced by it now being written into European securities industry regulation.

I think every business also needs a bit of luck, and we benefited from establishing ourselves in London in the early 2000s, when there was a plethora of mining and natural resources companies listed there. Sadly, there was very little aftermarket care for those companies, because there was simply not enough analyst bandwidth available to cover them. We signed up quite a few of them for our service. I believe Edison has been successful thanks to a combination of identifying a need in the market, passion and a bit of luck.

How much change to the traditional business model for institutional equities have you seen over the past ten years? What have the biggest changes been?

The first thing I would say is that an increasing amount of money has been moved to global mandates. One of the things that surprised me about the Edison business is that while it started off as a UK business, it became international pretty quickly and our product is consumed globally. Second, there is increasing profitability pressure on the sell side due to regulation, and higher pressure on the buy side’s capability to make money. I also think that there is more transparency now regarding what the buy side is actually paying for. There are a lot of surveys and benchmarks to compare different research providers.

As a consequence, the number of sell-side analysts has declined. Ultimately, in an industry where there are no prices, it is rather hard to get an adequate resource allocation and the fact that you put a firm price on research means that we will start to see resources being allocated more optimally.

How do you expect MiFID II regulation to affect asset management and equities businesses, and how will this in turn affect listed companies?

I think that there are three things around MiFID II worth highlighting. First, the compliance burden is significant, and I think that it will lead to consolidation, on the sell side and the buy side. Fund managers and brokers alike need economies of scale to be able to afford running the compliance streams and processes needed.

Second, under MiFID II everyone also needs to put a price on their research. Initially, the thinking was that the best quality research will survive, but I do not totally believe in that. I think that the players with the biggest and strongest balance sheets can afford to bite the bullet and blitz their way through the first shockwave of regulation-induced disruption of the industry. An example of this is JP Morgan putting a USD 10,000 price tag on full access to its research platform, which is putting an enormous amount of pressure on the rest of the investment research industry. I doubt that many firms have the financial strength to survive two or three years of that, in order to emerge in a landscape of fewer players at the other end. I think MiFID II will force a number of players to exit from investment research, with pricing bottoming and ultimately improving as the industry consolidates.

Third, I think corporates will start working differently with the securities industry’s sell side within corporate access. It is currently often complicated, as no single sell-side institution has unlimited access to the whole investor market. Looking at what some leading companies are doing, Tesco did not use a bank for their recent post-results road show. They used an independent firm, because they didn’t want access to their management to be restricted by sell-side client lists. I think more companies will take that approach in the future. Ultimately, a lot of the MiFID II language is arguably urging the buy side to establish direct contact with corporates, encouraging them to produce more information on the understanding that there is going to be less research. The corporates are going to have to fund this increased information flow through their own investor relations budgets going forward, which is not necessarily a bad thing, since it puts control back into the hands of the company itself.

I had a fund manager in here the other day, and I asked her what she would like corporates to do in response to MiFID II. She made two observations

  1. If a bank is claiming to be an independent research provider and gets institutions to pay for that research, she felt very strongly that the analysts of that bank should not have any privileges, i.e. not being wall crossed ahead of results, etc.
  2. There is a real concern around the reliability of consensus forecast numbers, as banks no longer necessarily put all their forecasts and research on platforms. She felt that companies themselves ought to collect consensus data, because they are the ones to who know best.

Management of expectations for corporate financial performance is key; it ties into cost of capital, liquidity and volatility, so it has real implications. Problems may arise if issuers don’t have a clear idea of what the market is thinking and they have a regulatory obligation to update the market.

What can listed companies do to stimulate interest in their shares, and to help ensure their shares get a fair and fundamentally based valuation?

The first thing they can do, in the absence of lots of sell-side research, is to make sure the information they put on their own website helps investors get a proper understanding of the business. You can break that into several different components:

  • An elevator pitch – if you can’t describe your business in a few lines, time and resource-constrained investors will not wrap their head around it, and rather move on to look at another company.
  • Present a bit more of the history of the business on the website, along with a description of the industry and the company’s strategy going forward. I believe this is an increasing area for growth in investment research going forward, particularly in terms of how you get all that information compiled and put together. There are some great examples of some home-building companies here in the UK who update their information on a regular, real time basis, so if you go to their website, you get fresh and useful statistics effectively.
  • Report on the ESG side of things. This is an increasing part of investment mandates, and I really think that every company should have something on their website in terms of governance and their social responsibility, basically everything that major institutions like BlackRock have very publicly highlighted as a critical focus.
  • Simple things that I believe make a difference, like general and financial information, consensus forecasts, and a list of the analysts that are following the company.
  • Make sure that the information is consistent with the annual report. There are so many examples of companies saying one thing in their annual report, while their website is saying something completely different.

You also need to target investors. Every company is different. They need to decide what sort of investor base they are aiming for and make a clear plan for how to achieve it. You may go with an independent research provider to give you very broad access, and at the same time I have come across some very clever individuals at companies who have picked two brokers because they are targeting 50 specific investors they want to reach, and they know these 50 funds are familiar with and work with these particular brokers.

Companies also need to think about how they will get investor feedback, which can be particularly difficult for companies that do not host capital markets days. If you want to be a listed company, you need to commit resources to feedback channels.

One example I use is to ask you to imagine you are going to buy a sofa, and there are two sofas available to choose from. One just has a price tag and is on display in the showroom. The other sofa has both a price tag and a very supportive and helpful salesman. Which sofa will you ultimately buy? Probably the latter. Chances are high that institutional investors will have the same thinking when it comes to investing in companies. If you make it easy for investors to invest in your business, the benefits of being listed should outweigh the costs and regulatory hassle.

Are there any disadvantages or challenges associated with a commissioned equity research service? Conflicts of interest? Others?

According to academic literature, a research desk does help with liquidity and drive down the cost of capital, but it needs to have credible research. Institutions and corporates need to choose research vendors with a good brand and reputation. They should also look at the CFA [Chartered Financial Analyst] guidelines, and go with vendors who take payment in cash, and not in stock. There are some independent research firms out there that are getting paid in warrants, which really lead to credibility issues. It should be transparent, disclosed properly, and it should always be cash payment.

You should also be aware of the fact that you are going to get an independent assessment of the business, so credibility is really important, otherwise the research won’t have any impact.

We have some clients in Scandinavia who are subscribing to a commissioned research service from a local player like Redeye. We have found that those local players reach a specific local investment community, while the same clients retain us to give them a more international, institutional investor exposure.

Questions used to be raised that if you pay for coverage, whether this would mean that no one else would want to cover you. I think we are past that now. Edison has been going for 15 years, people know who we are, and institutional investors often say that our analysis is the best on some of the companies we have been retained to cover.

One of my constant worries, however, is that it has taken a long time to build the independent research industry up sensibly, but it would only take one or two rogue players acting irresponsibly to put the whole thing in disrepute. You saw that in the US in the early 2000s, where there were firms shorting the stocks they were also writing research reports on. But this reputational risk applies to the traditional equity business as well. Just look at the aftermath of the global financial crisis – at the end of the day, that has also been the driving force behind the avalanche of financial industry regulations that we see today.

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Johan Trocmé | Director, Thematic Research | +46 101 56 34 22 | Analyst info

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