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Equity Research: What's Next?

Prudential's purge is the latest change in the industry as research-settlement funding dries up and hedge funds poach top analysts

When Ben Rose started his own stock research firm, Battle Road Research, back in 2001, he wanted to examine companies in a different way. Instead of starting with sit-downs with corporate execs, he would start by talking to customers, suppliers, and industry experts, people whose unbiased reviews cut through the typical press releases and industry show pitches. Rose calls his method "doing [what] analysts were paid to do in the good old days."

Battle Road is one of hundreds of independent research shops that have sprung up in recent years, with a variety of methods and areas of focus. "No one has figured out the secret sauce to conducting equity research," Rose said. "There are different approaches, all of which have validity in the marketplace."

Analysts Move to Buy-Side Firms

But finding ways to make money from providing all this research is getting more difficult. This was underscored on June 6 when Prudential Financial (PRU) closed down its equity research operations, Prudential Equity Group, and laid off more than 400 employees, including 33 senior analysts.

Few in the industry think Prudential's analysts will have trouble getting new work. Demand for analysts is strong, but the landscape has shifted. More research dollars are flowing away from firms such as Battle Road or Prudential, so-called "sell side" firms that sell their research to others. Instead, "buy side" firms such as hedge funds and other money managers are hiring in-house research staffs, paying top dollar to keep those investing insights all to themselves.

Much of the work done by Battle Road's tiny staff goes out to its clients through something called "soft dollars." Money managers pay higher trading fees, and in exchange, trading firms provide their clients with research by firms such as Battle Road. Last year, the Securities & Exchange Commission moved to restrict the use of soft dollars, and last week SEC Chairman Christopher Cox said he may lobby Congress to ban the practice altogether. "This witch's brew of hidden fees, conflicts of interest, and complexity of application is at odds with the investor's best interest," Cox said.

Fallout from 2003 Settlement

Soft dollars' supporters say no one is being deceived. The practice rewards the best research, and spreads it to a wider audience, proponents say. "The SEC has systematically undermined the business model and payment system for research," says Scott Cleland of the research firm Precursor.

Cleland used to be an independent analyst, and he proudly describes pointing out problems at WorldCom before others realized anything was wrong. However, he quit at the end of 2005 to do research for industry instead, saying the economic model for independent research just wasn't working. He's particularly critical of the 2003 global research analyst settlement, which was a result of analyst scandals in which banking deals tainted top firms' research. The deal, with the biggest Wall Street firms, separated investment banking from research operations, ending a key way those firms justified research costs.

The agreement also meant that big brokers would pay $450 million toward giving their clients independent research. The settlement, while well-intentioned, ended up giving lots of research away for free, Cleland said, setting "the market price for independent research at zero."

Money from the research settlement dries up in mid-2009, and no one knows whether big brokers will continue offering the extra research alongside their own.

New Business Models

While funding dries up for traditional sell-side research firms, resources and talent migrate to the buy side, the many money managers, hedge funds, and private equity firms beefing up their internal research operations, said Jeff Diermeier, president and chief executive of the CFA Institute. Analysts, along with business-school professors and administrators, say there's a perception that sell-side research, once a place where top analysts made top dollar, is not where the rewards are.

All the uncertainty is driving the research industry to come up with new business models. Some firms farm themselves out to money managers for specific research projects. Others sell research directly to investors through subscriptions. Some big firms are restricting wider access to their top researchers, using their insights for in-house trading.

"There's still demand for innovative research," said John Eade, president of Argus Research. "There's less and less demand for traditional sell-side research." Firms must come up with innovative methods or new ways to exploit research insights. For example, "few people need another e-mail report coming to them," but many investors will pay for time on the phone with a top analyst, Eade said.

Yet it's an open question how much sell-side research could survive without soft dollars. It could hurt smaller firms, Diermeier said, but using hard dollars should result in a better, more efficient allocation of research money.

Company-Funded Research

How much would investors pay directly for research, and would it be enough to make up for the loss of soft-dollar funds? "There is a fear in the industry that firms [won't] pay for research," Rose said. That may sound unlikely, but many point to the fixed-income market, where corporations, not potential investors, pay Standard & Poor's and Moody's to evaluate debt. Could that happen to equities?

Actually, that business model is already being tested as a way to spur coverage of smaller publicly traded companies.

Instead of covering every firm, research firms all seem to chase stocks with higher trading volume. The result? "Investors are not getting exposed to companies that are early in their growth cycle," said Karin McKinnell, president of the Independent Research Network. The lack of exposure means investors miss opportunities and small companies end up with higher capital costs.

Many smaller publicly traded firms have lost coverage as research budgets shrink. About a quarter of all public companies are not covered by a sell-side analyst. A total of 43% have two or fewer analysts covering their stock, according to data collected by IRN.

Middle Man Could Aid Objectivity

The Independent Research Network, a joint venture of Reuters and NASDAQ (NDAQ), places itself as a middle man, enabling companies to hire research firms to cover them. The National Research Exchange has a similar business plan. Some are suspicious of any research funded by the companies being researched. McKinnell said IRN provides "multiple levels of protection," including a code of ethics, an oversight board, and two- to three-year contracts for all research coverage.

Nobody is sure where all this is leading equity research. But independent, sell-side firms say they provide a valuable service to markets. They spread information, helping markets work efficiently, and they're a key ally to investors. "Our views are aligned with investors," Eade said. "Our business interests are the same."

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