Equity Research

Definition

Equity Research is the study of stocks on the basis of their fundamental parameters which aims at analysing the companies in order to find possible investment opportunities. Equity research professionals are known most generally as "analysts", "research analysts", or "Equity analysts"; all the foregoing terms are synonymous. Research analysts are commonly divided between the two basic kinds: equity analysts (researching stocks and their issuers) and fixed income analysts (researching bond issuers). However, there are some analysts who cover all of the securities of a particular issuer, stocks and bonds alike.
The role of research is to provide information to the market. An efficient market relies on information: a lack of information creates inefficiencies that result in stocks being misrepresented (over or under valued). Analysts use their expertise and spend a lot of time analyzing a stock, its industry and peer group to provide earnings and valuation estimates. Research is valuable because it fills information gaps so that each individual investor does not need to analyze every stock. This division of labor makes the market more efficient.

Research in Bull and Bear Markets
If the role of research has always been so "noble", why is it currently in such a state of ill-repute? There are two reasons: firstly the current bear market gives us a new perspective to evaluate the excesses of the last bull market; secondly investors need to blame somebody.
In every bull market there are excesses that become apparent only in the bear market that follows. Whether it is tulips or transistors, each age has its mania that distorts the normal functioning of the market. In the rush to make money, rationality is the first casualty. Investors rush to jump on the bandwagon and the market over-allocates capital to the "hot" sector(s). The most recent examples being web-based grocery companies, online pet stores and fiber-optic capacity. This herd mentality is the reason why bull markets have funded so many "me-too" ideas throughout history.
Research is a function of the market and is influenced by these swings. In a bull market, investment bankers, the media and investors pressure analysts to focus on the hot sectors. Some analysts morph into promoters as they ride the market. Those analysts that remain rational practitioners are ignored, and their research reports go unread. During the late 1990s the business media catered to the audience’s demands and gave the spotlight to the famous talking heads that are now under investigation.
Seeking to blame someone for investment losses is a normal event in bear markets. It happened in the 1930s and the 1970s and is occurring today. Some of the criticisms are deserved, but the need to provide information has not changed.
In today’s market, we need to differentiate between Wall Street research and other research. Wall Street research is provided by the major brokerage firms (both on and off Wall Street). Other research is produced by independent research firms and small boutique brokerage firms.
This differentiation is important. First, Wall Street research has become focused on big cap, very liquid stocks and ignores the majority (over 60% based on our research) of publicly-traded stocks. This myopic focus on a small number of stocks is the result of deregulation and industry consolidation. In order to remain profitable, Wall Street firms have focused on big-cap stocks to generate highly lucrative investment banking deals and trading profits.
Those companies that are likely to provide the research firms with a sizable investment banking deals are the stocks that are determined worth being followed by the market. The stock’s long-term investment potential is secondary. The second reason to distinguish Wall Street from other research is that most of the blame for the excesses of the last bull market is rightfully placed on Wall Street.
Other research is filling the information gap created by Wall Street. Independent research firms and boutique brokerage firms are providing research on the stocks that have been orphaned by Wall Street. Investors, now educated in the benefits of electronic trading, may not be willing to support boutique brokerage firms for their research by opening an account and paying higher commissions.
This means that independent research firms are becoming the main source of information on the majority of stocks, but investors are reluctant to pay for research because they don’t really know what they are paying for until well after the purchase. Unfortunately not all research is worth buying. I have purchased reports from reputable sources only to find them inaccurate and misleading.
The ironic thing is that while research has proven to be valuable, individual investors do not seem to want to pay for it. This may be because, under the traditional system, brokerage houses provided research in order to gain and keep clients. Investors just had to ask their brokers for a report and retained it at no charge. What seems to have gone unrealized is that the commissions pay for that research.
A good indicator of the value of research is the amount institutional investors are willing to pay for it. Institutional investors hire their own analysts to gain a competitive edge over other investors. They also pay (often handsomely) independent research firms for additional research. Institutions also pay for the sell-side research they receive (either with dollars or by giving the supplying brokerage firm trades to execute). All this amounts to big money, but the institutions realize that research is integral to making successful investment decisions.
If investors are unwilling to buy research how will the market correct the imbalance caused by the lack of coverage? The solution may be found by looking at the issue a slightly different way.
Fee-based research increases market efficiency and bridges the gap between investors who want research (without paying) and companies who realize that Wall Street is not likely to provide research on their stock. Fee-based research provides information to the widest possible audience at no charge to the reader because the subject company has funded the research.
It is important to differentiate between objective fee-based research and research that is promotional. Objective fee-based research is analogous to the role of your physician. You pay a physician not to tell you that you feel good but to give you his or her professional and truthful opinion of your condition. Legitimate fee-based research is a professional and objective analysis and opinion of a company’s investment potential. Promotional research is short on analysis and full of hype. An example is the fax and email reports about the penny stocks that will supposedly triple in a short time.
Legitimate fee-based research firms have the following characteristics:

• They provide analytical not promotional services.
• They are paid a set annual fee in cash; they do not accept any form of equity, which may cause conflicts of interest.
• They provide full and clear disclosure of the relationship between the company and the research firm so investors can evaluate objectivity.

Companies who engage a legitimate fee-based research firm to analyze their stock are trying to get information to investors and improve market efficiency. Such a company is making the following important statements:

1. That it believes its shares are undervalued because investor are not aware of the company.
2. That it is aware that Wall Street is no longer an option.
3. That it believes that its investment potential can withstand objective analysis.

More importantly, the reputations/credibility of the company and the research firm depends on the efforts they make to inform investors. A company does not want to be tarnished by being associated with disreputable research. Similarly, a research firm will only want to analyze companies that have strong fundamentals and long-term investment potential.

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