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Asset managers in receipt of yet another obvious “hold” recommendation to their inbox may struggle on occasion to see the value of analyst research. Not so UK government adviser Rachel Kent, who is seeking to recast it as a public good, deserving of collective funding.
The newly-published Investment Research Review, which was led by Kent, certainly won’t deliver miracles for the UK’s struggling capital markets. But it is, broadly speaking, on the right track.
The review, which was published at the start of the week, highlights how much investment research budgets have been cut. Rules in the EU’s 2018 MIFID II directive — which require asset managers to pay separately for investment research and were enthusiastically implemented by UK regulators — have exacerbated the trend.
Kent posits that the declining volume and quality of investment research should carry some of the blame for the City of London’s problems. Other contributing factors include Brexit and the declining equity exposure of UK pension funds.
Kent presents a number of recommendations to encourage wider research coverage, particularly in the under-represented small and mid-cap markets.
Her enthusiasm for research makes sense. Well-crafted analyst notes spark investor interest in stocks. That can help companies reach and maintain appropriate valuations. The result is a healthy ecosystem that is attractive to new businesses seeking to list.
In the UK, however, this ecosystem is struggling. Spending on research has fallen. Brokers are cutting research departments and delegating more responsibility to junior analysts. Coverage of small and mid-cap stocks has been hit the hardest because there is less investor interest to justify fees and staffing.
“The withdrawal of coverage for smaller stocks has an impact on these firms’ cost of capital”, said Simon French, head of research at Panmure Gordon. “They trade at a discount of 35 to 40 per cent compared to their global peers, while the broader UK market discount is around 20 per cent”. It’s a problem for individual companies but also for the UK economy if it wants to encourage new businesses that will innovate, grow and create jobs.
The research review recommends dismantling some of the MIFID II rules, to enable the “re-bundling” of research costs with trading and other commissions. However, lumping different costs together makes little sense and asset managers now have MIFID II compliant structures, which they are unlikely to dismantle.
More usefully, the review suggests making it easier for fund managers to recoup research costs from their investor clients. If existing rules that make it difficult to do so were reformed, fund managers would have more money to spend on research.
Even more interesting is the proposal to create a collectively-funded “Research Platform”, a third-party body that would commission and pay for research, mainly on behalf of small and mid-cap companies. The idea is that every company would be guaranteed coverage by at least three analysts.
“Mutualisation is a good idea”, said Adam Forsyth, head of research at Longspur capital, a company whose research is paid for by issuers. “As things stand, smaller companies cannot attract sufficient research coverage to raise their profile with investors and that is a systemic issue.”
It is quite a big challenge though. Mark Hiley, founder of independent research provider The Analyst, estimates that there are more than 200 research analysts covering UK mid-cap companies and in 2020 they issued more than 1,600 recommendations between them. If every listed stock required three recommendations, that would imply more than 6,000 recommendations, or a fourfold increase in the number of analysts, assuming they maintained the same productivity.
Another key question is how the platform would be funded. The review puts forward a number of models. One is to make investment banks foot the bill, on the theory that they would recoup these costs elsewhere if the IPO market recovered. Alternatively, the companies covered could collectively pay for research, given the expected support to their valuations. A third proposal would be for investors to pay, perhaps alongside trading fees.
The mutualisation of research costs is, conceptually, a long way from the MIFID II rules. These treated research as a product that institutional investors could choose to buy if they wanted to. But, by failing to account for the broader role of research in well-functioning markets, the reforms unwittingly contributed to London’s current malaise. Kent’s proposals wouldn’t reverse this decline but they are a step in the right direction.
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