Equity Research: What's Next?

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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."

Steverman is a reporter for BusinessWeek's Investing channel.