INVESTMENT BANKS´ CULL OF COMPANY ANALYSTS BRING DANGERS / THE ECONOMIST

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Investment banks’ cull of company analysts brings dangers

The baby of astute analysis risks being thrown out with the bathwater of corporate soft soap

THEY are not extinct, nor even on the endangered-species list. But company analysts, once among the most prestigious professionals in the stockmarket, are being culled. New European rules, with the catchy name of MiFID2, have just dealt analysts another blow. A study by Greenwich Associates estimates that the budget for the research they perform may drop by 20% this year.

In their heyday in the late 1980s and early 1990s, analysts could make or break corporate reputations. A “buy” or “sell” recommendation from the leading two or three analysts in an industry could move a share price substantially. Fund managers, and many financial journalists, relied on analysts to spot those companies that were on a rising trajectory, and those where the accounts revealed signs of imminent trouble. And the best analysts were very well paid.

But that golden age was built on some rusty foundations. Analysts were well paid because they worked for the big investment banks. But those big banks made money not just by helping investors to trade but also by advising companies on new issues, and on mergers and acquisitions. In such circumstances, there was an implicit bargain that analysts would be positive about a company’s prospects. If they were not, the chief executive might take his business elsewhere. Over time, “buy” recommendations far exceeded “sell” suggestions. This looked less like dispassionate analysis than marketing.

A second problem came in the 2000s as regulators cracked down on the way that companies released news to the market. Information could no longer be selectively released to favoured analysts. By the same token, those “Sherlock-like” analysts who liked to spot trends through independent company visits faced difficulties. Everything came to depend on the profits guidance issued by companies for the next quarter or year. And analysts dared not let their forecasts stray too far from what the companies suggested. The paradoxical result was that finance, an industry whose acolytes often trumpet the superiority of free-market economics, had created a poorly functioning market—one that was oversupplied with analysts who mostly offered the same product.

Why, then, did it survive at all? The conventional way that investors rewarded banks for good research was not to pay for it directly, but to funnel securities trades their way. This system of “soft” commissions created two conflict-of-interest questions. Were fund managers trading more than they needed to just to pay for their research? And were they getting the best terms available when they did that trade? In both cases, the client, not the fund manager, was in effect paying for the service. There was little incentive to change.

Under the new MiFID rules, banks will not be allowed to bundle research up with other products. Fund managers will have to pay for it separately. As a result, they are expected to be much more selective. This recalls Dr Johnson’s response when Boswell asked whether the Giant’s Causeway in Northern Ireland was worth seeing. The great man replied: “Worth seeing, yes; but not worth going to see.” The suspicion is that, for many fund managers, the work of analysts is “worth having, but not worth paying to have”.

The rules may technically apply only to Europe but even American investment banks are expected to adjust their business models to cope with MiFID. The employment prospects of analysts had already been hit by index-tracking, or “passive” fund management, which simply buys all the shares in a benchmark, and by the growth of quantitative hedge funds, which use computer programs to select stocks.

But the best analysts need not despair completely. The biggest fund managers employ in-house research. Some may be willing to pay for analysis from independent boutiques (as has been the case in the world of economics).

The fear, however, is that something will be lost in the process. For all their faults, analysts acted as conduits for company information to be passed to investors who could not afford their own research (charities and small pension funds, for example) and, via the media, to the general public. A few heroic analysts (one thinks of Richard Hannah, a long-term Eurotunnel sceptic) proved adept at exposing corporate flimflam.

Alas, the industry generated far too few sceptics and far too many corporate cheerleaders. The baby is being thrown out with the bathwater—but in recent times it was a very small baby amid an awful lot of murky water.