Quoted companies rely heavily on research produced by stock-brokers to persuade investors to buy their shares. This is rather erroneous.
Stock-broker or ‘sell-side’ research does have its merits. It can be a useful source of information and data for the market to absorb and process. Sell-side analysts have privileged access to company management and arrange regular meetings for their fund manager clients (the ‘buy-side’).
However, broker research falls short in one critical area. It rarely persuades fund managers to invest.
A 2008 study by State Street Global Markets showed there to be zero correlation between analyst recommendation changes and institutional investment flows in 9 of the 11 MSCI Europe sectors. It concludes that buy-side investors disagree with sell-side upgrades or downgrades to such an extent that they are more inclined to act against the advice than with it.
There are several reasons for this. Statistically, sell-side analysts have a poor record in predicting future earnings. This makes investors wary of the forecasting models that are so keenly built. Also the use of somewhat arbitrary valuation models to justify share price targets tends to be a bit of a turn off.
Probably the most powerful explanation, however, is that sell-side and buy-side are simply misaligned. Stock-brokers are hugely incentivised to grow their commission income by encouraging fund managers to trade regularly. Fund managers, on the other hand, are incentivised to beat the market after costs - a key component of costs being of course trading. The conflict of interest is obvious.
Further, investment banks typically use income from corporate clients and other areas to subsidise their research overheads. The sell-side analyst is unable to serve two masters and naturally defaults to keeping the internal customer happy.
Research supplied to investors by independent houses such as Edison does in part mitigate the problem. However there is no substitute for direct marketing – the DIY solution. Meeting investors face to face is the most powerful marketing tool that company executives possess.
Listed companies, especially the smaller ones, must revert to Shanks’ pony if they are serious about growing their institutional shareholder base.
This is nothing new of course. Many fund managers have corporate access as central to their investment process, and most companies have in place a systematic programme of institutional investor meetings. In fact the FSA goes so far as to classify the investor road-show as a ‘financial promotion’ (presumably of the company’s own shares).
Why then do so many of these meetings end in frustration – for both parties?
The answer lies in the approach of management and the type of information they provide.
For instance, any professional investor worth his salt can spot a bluffer at a hundred paces. Failure to demonstrate integrity and candour is a one way ticket to the spin graveyard! Fund manager respect goes hand in hand with a stable, supportive institutional shareholder base and must never be compromised.
Most companies do not identify clearly enough the information that is required by professional investors.
Management must learn to concentrate less on short term issues, such as the latest earnings release, and more on how they allocate capital for the long term benefit of the shareholder. What levels of return are expected from current projects and what are the risks to those returns? Where in the profits cycle is the business and when is the optimum time for the company to invest in new projects? Is it better to invest capital in the business or return capital to allow the shareholder to seek higher returns elsewhere?
Management rarely spend enough time explaining their company’s financial position. Peter Lynch, famed manager of the Fidelity Magellan mutual fund, once advised ‘Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets’. The same can be said for companies that consistently fail to convert profits into cash-flow. Management must do more to convince investors that their balance sheet and cash generation are both in order. If the company has an inferior financial position, then management should detail a realistic timetable for improvement.
Information is the lifeblood of the fund management industry. Good information supplied by management can go a long way to building a high quality, supportive shareholder base. Bad information can be fatal!
