I've been off the grid for the last two weeks, out in Fuerteventura, one of the Canary Islands off the coast of Africa. During my time, I had the chance to catch up on some reading, specifically Michael Lewis's Boomerang. What can I say, Lewis has been an incredible writer, telling the story in a way that is both entertaining and educational, with a morality check to boot. Interesting read for anyone who's missed it.
One of the themes that came out both in "Boomerang" and "The Big Short" involved the negligence of the ratings agencies and the analysts and managers of CDO portfolios who willfully bet on the music not stopping. Lewis argued that many of these folks were just mismatched and didn't remotely understand the securities they were reviewing or investing in - the others were just out to manipulate the markets (and probably should be put in prison). Lewis also notes that the market was fairly aware that the market was frothy and that analysts were probably putting out reports that were overly optimistic.
Why Research is Needed
The fact is, the research and analysis market is still very robust for one very specific reason - due diligence is hard to do in a vacuum and expertise is always valued in making investments (as my dad used to say "its important to 'buy a little brain' from time to time).
As a VC at Greylock, we relied heavily on the greater Greylock network to better understand the startup's team, the market, competitors, potential acquirers, and the quality of the product. Since our investments were in the private markets, and often in new industries, our 'experts' were bloggers, executives from potential acquirers and related firms, and technical experts. We rarely used investment bankers, as valuation was loosely structured on industry comps (from VentureSource or some equivalent service). We always included legal advisors in constructing the right term sheets for the investments once we agreed to move forward.
The same approach is applied in the PE world and the public markets, but with different data sources. In the PE world and Public Markets, buy-side firms have hard-data to construct valuations in a smarter way, resulting in a heavier emphasis on internal and external analysis on that front (think investment bankers on the PE side and sales traders on the public side providing pricing guidance). Additionally, there is a larger market of information and comps to draw insights from, namely the company's executives (think investor relations / corporate access), market research analysts from the likes of Gartner and Forrester, experts from the likes of GLG and professional analysts from large investment firms (sell-side) and independent shops.
But Research has Changed
Sadly, for our friends in Investment Research, the last 15 years have seen major changes. During the dot com bubble, a variety of analysts became superstars on CNBC, including folks like Henry Blodget, Mary Meeker, and Jack Grubman - these guys and many of their colleagues were incentivized to be bullish on securities that were issued by firms doing lucrative investment banking business with their firms - e.g. in exchange for a positive rating, the firm got larger allocations of IB fees. After the bubble burst, Spitzer went after the Sell-Side Research firms, and made several key changes to the industry, namely:
- Institutionalized a chinese wall between Investment Banking and Research to ensure that analysts were more objective
- Create pools of resources for these firms to allocate and promote independent research content, coming from firms who did not have investment banking or a broker-dealer in-house, again ensuring a wider array of opinions and objective analysis
Investment Research, generally a 'soft dollar' or 'loss leader' business, conducted to induce investment banking and trading revenues, now would be forced to either go 'hard dollar' (charge a fee for research directly) or rely on the latter only.
A few years later in 2006, 'best execution' requirements further solidified the shift to 'hard dollars' in mid-market and smaller shops, as it forced the buy-side to conduct the most efficient trade at the given moment, not the right trade within a 'soft dollar' arrangement (e.g. trading off a few bp in exchange for the research that induced the trade). This further decoupled research as a stand-alone offering, ideally situated as a hard-dollar business line.
These changes came precisely during the decade of exponential information sharing and growth - retail investors on retail sites were getting access to real-time research and ideas shared from numerous sources. Consensus data, analyst projections, and research reports were openly available or passed around with relative ease across historical and newfound communications channels (think of the big Lazard report for Carl Icahn that became a web sensation in February 2006, and still shared all over the web).
During the same time, traditional publishers had their content tested by the general and financial public to determine its value - certain brands thrived (think WSJ, FT, NYTimes, The Economist, and several smaller, leaner web-based offerings) while others struggled heavily or fell apart (think nearly everyone else). Clearly, people were willing to pay for the best available content, but the bar had risen to determine who would succeed in this new information-rich world.
Value In Information
In the publishing world, firms like the NYTimes and organizations like Dow Jones were able to win the digital dollars by creating a lucrative new model in cyberspace - giving away a portion of content for free and supplementing such services with advertising. Their best writers leverage social media to build notoriety to encourage more eyeballs to look at the content to drive those two business models (subscribers and ad traffic).
In the research world, firms on the sell-side push their research reports to both clients and potential clients (basically the bulk of the buy-side) for free, with the hope that clients will reach out to their analysts for both corporate access (opportunities to meet management) and analysts access (opportunities to pick the brains of the analyst over the phone or in person).
Today, most top-tier sell-side shops, who can ensure 'best execution' via their trading desks, can still afford to manage their research business via soft-dollars, but the rest of the sell-side and the independents make all of their money through hard-dollar arrangements. To be successful in a hard-dollar environment, analyst insights need to be considered highly valuable and essential to investment decisions - it can no longer be reliant on 'relationships' or some intangible connection for other business.
Selling Valuable Content
Again looking to the publishing business for answers, we can see a variety of approaches, namely the freemium model vs. the walled garden approach. In the freemium model, a taste of the content is shared with the potential customer to entice them to buy - sites actively push their best writers and content to be accessible to this audience, as it will encourage subscription and ad dollars rolling in. Alternatively, in the walled-garden model, the firm relies on its existing reputation to sell their content, generally sight unseen - this requires the very strongest of brand names in the market.
In the research world, a large amount of content is produced and shared through a variety of private channels (e-mail, databases, brokerage firms, and through financial news agencies), with the intent of building brand with existing and potential clients. The goal is to build enough credibility around specific securities, industries and macroeconomic areas to be worthy of client research budgets, which can easily be in the seven or eight figures for the larger firms.
Social as a Distribution Channel
Again, the publishing industry has largely embraced Twitter to push content to the masses and establish/extend the brand of the firms and their individual writers. It has been able to expand empires (think Thomas Friedman) and build new ones (think Mashable, HuffPo and BusinessInsider), particularly in the smaller and less-established firms.
On the research side, embracing StockTwits as a distribution channel is a modern alternative to the traditional research freemium model of database and dissemination through the news agencies - allowing the firm and their analysts to own the content being shared, how it gets shared, and follow the engagement from the community. With the research community sharing their basic thesis and analysis with the greater investment community on StockTwits, they will ensure attribution with the firm and analyst, and enabling fully-trackable engagement from both market influencers and potential clients. The result is a highly effective, yet simple way to be a part of the more transparent information market (actively, as apposed to being dragged into it, kicking and screaming), building clout and brand with the right audience who can be long-term clients.
Seems like a smart approach to me.
Look for it in 2012...