Investing

Stock Research: An Uncertain Future


For the average individual investor, getting good information on stocks and other investments has never been easy.

It's about to get more difficult.

Fewer analysts are covering fewer companies. This trend of shrinking coverage is expected to continue for two reasons: The financial woes of Wall Street firms and the end of a five-year settlement to fund independent equity research.

Furthermore, top analysts are setting up their own firms (with limited client lists) and moving to hedge funds or other "buy-side" institutions. That means much of the best analysis is going behind closed doors, where it's harder for individual investors to access.

Independent Research Agreement Expires

Complaints about the quality of Wall Street research are not new. Five years ago, ten major Wall Street firms agreed to provide customers with independent research to settle claims that their in-house research was biased.

That agreement, which set aside about $90 million per year for independent research, ends in July.

Two of the biggest providers of settlement-funded research have been Morningstar (MORN) and Standard & Poor's. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP).)

Morningstar has disclosed that research settlement money made up about 4% of its 2008 consolidated revenue, about $20 million. According to Sanford Bragg, chief executive of Integrity Research Associates, which tracks trends in the equity research industry, S&P seems to be receiving a similar share of settlement dollars, with another smaller but significant share to Argus Research. "The majority of independent providers were getting zero or small amounts," Bragg says.

What's Next for Top Analysts?

Both Morningstar and S&P say they will continue covering a broad array of stocks. Even if the big investment firms stop paying for the research, executives at Morningstar and S&P say they will continue selling it through other channels, including their own Web sites.

"We'll continue to have broad coverage," says Catherine Odelbo, president of Morningstar's equity research group. However, she adds, "We may adjust that coverage based on client demand."

Under settlement research contracts, certain firms must be covered, even though "we know for a fact that no one is interested in them," she says. "We'll have a lot more freedom to adjust the coverage," she added.

Odelbo and Stephen Biggar, head of equity research at S&P, both say they're in negotiations with investment firms to continue providing them with research.

"They're in the decision-making process right now," Biggar says. Thus, the amount of Wall Street dollars for independent research "wouldn't go … to zero."

Wall Street's Shrinking Research Budget

However, the big firms that having been paying for research are in no position to be generous. Several—Lehman Brothers, Bear Stearns, and Merrill Lynch—no longer exist as independent entities. The survivors on Wall Street are laying off thousands of employees and are still navigating the worst financial crisis in a lifetime.

"It's not clear what they're going to do," Bragg says. Some firms will stop offering independent research entirely to their clients, particularly if few of those clients are retail investors. But the thousands of retail customers and financial advisors at firms like Bank of America (BAC), which acquired retail giant Merrill Lynch, may demand those second opinions.

By mid-summer, it will be clearer whether these firms can afford third-party research.

The layoffs in the past year have included many of the top-ranked research analysts on Wall Street, Bragg says. Firms are axing entire divisions, stopping all coverage of entire sectors or industries.

The effect on the quality of research is significant, says Stephen McClellan, who spent 32 years as a top-ranked technology analyst, mostly at Salomon Brothers and Merrill Lynch.

"Research got to the point where it was a mile wide and an inch deep," McClellan says. "Now, with layoffs, it's going to be an inch wide and an inch deep."

Moving to Buy-Side

It's not just layoffs plaguing the industry, says McClellan, whose recent book is called Full of Bull: Do What Wall Street Does, Not What it Says, to Make Money in the Market.

Analysts at major firms spend too much time on bureaucratic red tape and marketing, he says, and not enough on research. Moreover, a range of influences, from the brokerage to institutional clients to CEOs of covered companies, "create bias toward positive opinions," he says.

In search of higher paychecks and to escape these influences, a growing number of analysts are setting up their own firms or moving to hedge funds or other buy-side institutions. One star financial analyst, Meredith Whitney, left Oppenheimer (OPY) in February to start her own boutique firm.

"Overall, spending on research is declining," Bragg says. However, when the average client fee for research is $30,000 to $60,000 or more, respected analysts "can make very good livings without attracting a lot of clients," Bragg says.

Individual Investors: Priced Out

The problem is much of this boutique research—and all in-house buy-side research—is off-limits to individual investors unless they're willing to pay top dollar. And research customers' willingness to pay depends on how valuable this research really is. For decades, research has been subsidized by investment banking operations and trading desks or by the global research settlement. Now investors must take out their wallets to get good advice on stocks.

"When [people] have to start paying for equity research, [they] could come to the conclusion it's not worth all that much to them at the margins," says Craig M. Lewis, professor at Vanderbilt University's Owen Graduate School of Management.

Lewis, however, has studied whether equity research is valuable to investors. He's concluded it is, sometimes: Analysts "provide the most information when they effectively cut across consensus," he says. "If you're affirming what everyone else believes," that's much less helpful.

Where, in the future, will these investing gems come from? And will individuals be able to afford them?

Online brokerages TD Ameritrade (AMTD) and Charles Schwab (SCHW) both say they will continue to offer both qualitative and quantitative research. Megan Haran, director of TD Ameritrade's investment strategy group, says some Wall Street and boutique firms are actually looking to sell their research on its platform. "They're looking for new revenue streams," she says.

Changes in equity research are just one symptom of the troubles on Wall Street, where the business model for the investment bank is under stress by the financial crisis and by new regulations on the way.

"There is a lot that's changing, and the dust hasn't really settled yet," Morningstar's Odelbo says.

One thing is unlikely to change. As McClellan puts it: "Wall Street is just not structured for individual investors."

On Wall Street, money talks. And those who can pay, whether they be big institutions or the very wealthy, will be first in line for the very best information and research.

Steverman is a reporter for BusinessWeek's Investing channel.

Steverman is a reporter for Bloomberg News in New York.

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