IndustryInsights

By David Olson
Senior Counselor,The Abernathy MacGregor Group Inc.

“Why did you insist on seeing these guys?” asked the analyst.

The sell-side analyst and the investor relations officer (IRO) stepped onto the elevator, as the analyst posed his question. The firm they were to see: a long-term holder the company visited every year. But they were missing from the initial meeting list proposed by the leading sell-side analyst sponsoring the road trip.

“They’re a long-term holder, a big one,” our IRO said. “We always see them.”

“That’s interesting; I never talk to them,” the sell-sider replied.

This recent story from a client got us thinking about the important changes in sell-side research, changes that should prompt any investor relations program to re-examine its understanding and relationship with the sell-side.

Our inquiry’s rooted in a simple question—Why wasn’t this well-respected sell-side analyst talking to this longterm institutional investor?

Changing Roles, New Realities

The sell-side still publishes earnings models, sets price targets, forms consensus and places “Buy,” “Hold,” and “Sell” ratings. They get quoted in the press, ask questions on earnings calls.

But, the role of the sell-side analyst has changed, materially. First came the post-Enron, WorldCom, dot-com bust and the resultant rebuilding of walls between investment banking and the sell-side. Then came the Tsunami of 2007 and 2008.

The tidal wave that swept away Bear Stearns and Lehman swept away many sell-siders in its backwash. Since then, the number of sell-side analysts has fallen for a majority of companies, according to a study by Thomson Reuters, who also says the volume of research produced by the sell-side is down 20 to 30 percent from pre-scandal days.

But the quality rather than the quantity of analysis should, at the end of the day, be most important. Our large capitalization clients sometimes wipe a collective brow over the continued welter of sell-siders providing coverage. One very large cap client IRO says: “Two or three of my analysts really do incredible work; another six or so do decent work; I just don’t know what to do about the rest.”

This client and others also tell us they see more and more analyst opinion changes based on faulty “facts” and rushed analysis.

But of all the forces pressuring the daunted sell-side analyst, the new trading reality that emerged in the wake of Enron/WorldCom remains the most powerful. The clue lies in our IRO’s puzzling experience. The fact is that our client’s respected but beleaguered analyst didn’t talk to this particular investment firm because, as long-term, buy-and-hold investors, they generate paltry commission dollars.

In contrast to the heady days of the dot-com era, in which investment bankers most influenced analysts’ pay, in recent years it has been the equity trading desks that assumed this role at many firms.

The finances of equity trading have become more and more challenging. Commission dollars have been squeezed by the largest institutions and more than a few brokerage firms have questioned whether or not they should even continue to provide equity research to their institutional clients. But this is not the most important consequence of these pressures.

Short-Term Focus

Two interrelated issues emerge from this environment – the increasing importance of a small but influential coterie of hedge funds and the rise of proprietary trading.

Any sophisticated IRO knows hedge funds come in many varieties, pursue many strategies, and serve a useful role in the markets. The hedge fund can be a valuable segment of any company’s shareholder base. However, a small, vocal and well-funded minority has come to dominate the short-term buzz about many stocks. As we have seen for some time now, this minority turns portfolios over more rapidly than traditional, long-only, mutual funds. At the extreme, these investors turn portfolios 200 to 300 percent—or more—a year. This intense short-term focus drives heavy trading, bringing much-needed commission dollars to the brokerage firms.

Trading desks understandably want the analyst to focus on these clients. That’s where the money is. Thus, the old line institutional money manager, long loyal to our client, never made this particular analyst’s radar screen.

So, ironically, one set of perverse incentives from the days when investment bankers “paid” the sell-side analysts, has been replaced by a new set of skewed incentives that emanate from the trading desk.

Given this bias, it should come as no surprise that on this same trip, as our client made the rounds of hedge funds, management was confronted with rat-a-tat shortterm questions. The word “catalyst” populated the meetings. The next quarter’s results were about as far forward as these investors wanted to look.

Our client also told us they found more and more sell-side analysts focused on these same short-term questions. This short-term focus has seemed to drive increased stock volatility. It has also led to eyebrow-raising opinion changes on occasion—explicable only if understood as a trigger for short-term trading opportunities. Clearly, the more “action” an analyst can create, the more the trading desk can trade and generate more commission dollars.

It’s Your Story—Tell It

These forces are larger than any individual analyst or firm and it is difficult to imagine they will vanish without the development of a new business model for sell-side analysis that works well for all. In the meantime, it’s clear that companies must take more responsibility— and time—to tell their story directly to the buy-side.

First, companies must embrace the fact that in the new era of direct, web-empowered communications, they have more power than ever to reach stockholders directly. Needless to say, sell-side coverage is valuable (invaluable for very small capitalization companies), but with information flows more fluid than ever, companies of all sizes, need to think more confidently about their potential to reach smart investors directly.

Second, as our large capitalization client told us, “You can tell your analyst who you want to meet and who you don’t. We’re big enough to tell them who we want to see.” If a company goes on a sell-side sponsored trip, the IRO simply shouldn’t accept the analyst’s meeting list as complete. The logistical aid the sell-side can provide in setting up investor meetings is useful, but that’s no reason to be limited to an audience with merely a short-term view.

Third, perhaps the single most important implication of these trends for IROs is that they—and their companies— must know how to target the buy-side, and then do it: whether through good sell-side help or as a company sponsored proposition only. Critical questions for the IRO include: do you know who owns your competitors? Who used to own your stock? What institutional investor might buy your stock based not on its sector, but its underlying financial characteristics? Given the changes in the analyst landscape, investor relations programs must have an independent, outbound program, regardless of how good their sell-side coverage might be.

Fourth, notwithstanding the cautions above, it makes no sense to do as some companies do, and refuse to meet with hedge funds. This approach not only comes across as evasive and defensive, it fails to differentiate among the many different types of hedge fund investors. The key in hedge fund meetings is to focus on the issues important from the company’s perspective so neither side suffers from any illusions. It’s important to remember that many hedge funds go long and can be supportive if they come to believe in the company and its management. So, while these meetings can be frustrating because of the frequent shortterm focus, they do have the potential to create a valued supporter over time.

While it’s clear the world of the sell-side analyst has changed, none of this is to suggest that companies ignore the sell-side. The best analysts remain invaluable and need to be cultivated. They need management time. They need to understand the company’s overall strategy and the numbers. IROs should continue to spend time making sure, to the extent that they can, that the sell-side analyst gets it.

But these changes also surely tell us that companies need to be even more focused on telling their story directly to investors and potential investors. In today’s world, you simply must tell your story—directly and often.

So, to sum up—

Don’t refuse to deal with sell-siders. Some can still do you good, sometimes a lot. Do differentiate and prioritize. Focus on lead steers, the ones others look up to.

Don’t expect sell-siders to introduce you to longterm prospects. Do ask and give them your target list. Don’t expect sell-siders to tell your long-term strategic story. Do tell it yourself, directly to the buy side. Use the media (carefully).

Don’t refuse to deal with hedge funds. They’re a potent force. Do control the conversation. Pivot past trading catalysts toward value creation strategies.

If you would like to discuss this article, please contact David Olson at 213-630-6550/dwo@abmac.com in Los Angeles or Jim MacGregor at 212-371-5999/ jtm@abmac.com in New York.