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Making Investment Research Pay

Following are my rough notes from AQ Research‘s recent conference on “The Future of Research”, on December 5.

The speakers on this very strong panel were:

 Scott Lessing, Chief Operating Officer, Citigroup Investment Research Shubh Saumya and

 Jai Sinha, Partners, Booz Allen David Weild IV, CEO,The National Research Exchange

 For more information on Booz Allen’s views on this subject, see their report, Saving Sell-Side Research.

 Lessing: This question [of how to make investment research pay] is less pressing than it used to be 2 years ago.

 We’re coming from a great year for our clients and research.

 There’s been a shift towards payment for quality of research Jai Sinha:

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News of death of research was greatly exaggerated. Components of value of research include distribution and service, as well as actual content.

Any time commissions are not explicit, there is waste. We don’t need to necessarily force change in the model Weild: Quality is in the eye of the beholder.

 What is quality to an actively traded hedge fund isn’t necessarily quality to a longer term account or a public company.

 I noticed Monika Schulz with Wall Street Letter in the back.

 She recently conducted an interview with Candace Browning, the Director of Research at Merrill Lynch.

Candace, when asked how the research product had changed, responded that it has become more “trading focused.” It’s clear that public companies are having a tougher and tougher time getting the support that they need from the largest sell-side firms to reach long-term investors.

These accounts don’t generate enough commission volume to merit much attention yet they are the most important accounts for CEOs to reach.

As a consequence, more firms will need to ensure aftermarket support themselves. Let me share one interesting anecdote: I was talking with the CEO of $350-$400M Australasia-based company.

 A bulge bracket firm was taking this CEO on an all-expenses paid roadshow in New York and Boston to see institutional investors. This CEO couldn’t believe his good fortune and asked me “Why?” I asked him to share the list of accounts he was visiting and it was clear that most of these accounts (e.g., Tiger, SAC, Goldman Sachs Principal Strategies) were so large as to likely be prohibited from owning a stock of his market capitalization.

The CEO went on to say that all of his conversations focused on industry trends and not his company a clear sign that they were mostly wasting his time.

We recently did a project for a $750M VC. They were working with a $500M company going public.

The bank with whom they were talking about going public didn’t have coverage on even one company with a market cap under $1billion.

While I might choose that firm to take me public, I sure need to be careful about who is going to support my “little” company in the aftermarket.

 Lessing We cover 3000 stocks. We’ve been expanding small/mid-cap stocks. Weild: We run one funny analysis. We look at daily volume per analyst per stock.

 This analytic shows that if you cover a firm within Dow 30, you’re still competing for more volume/analyst than smaller cap stocks.

In fact, the median Dow 30 stock generates about 300,000 shares of volume per analyst per day, which drops to about 90,000 shares per analyst per day for the median stock in the S&P 500.

 Compare this to the NASDAQ Composite, which is more actively traded than the NYSE Composite, and the median stock generates only about 30K shares per analyst per day.

 This is partly the reason why if you’re analyst #30 on IBM, you’re still competing for more volume than analyst #2 on a mid-cap stock.

 A rule of thumb is that you are generating about $0.01/share/day available to research. The balance is siphoned off by program trading and low cost algorithmic trading.

Thus, despite the fact that accounts reject the need for more “maintenance research” on large cap stocks, the fact is that the stocks are so broadly held and generate so much volume per analyst that the economics are compelling.

Lessing: Volume of trading doesn’t drive our coverage decisions; it’s investor interest. In addition, there is very little correlation to an idea that we generate and how we get paid.

 We can get paid in IBM trades for a small cap idea.

 Weild: Yes, but investor interest tends to be correlated to trading volume.

 Plus, your definition of small cap is apt to be higher than ours.

We’re looking at sub $500 million market cap companies and Citi is probably closer to $750 million and larger. Lessing: Agreed. Sinha: Unbundling will allow people to pay differentially.

Lessing: there’s room for many different payment models. We’re very adaptable in how we get paid. Greenwich Associates surveys say that 20-60% of commissions are allocated to research, and rest is execution (capital commitment, execution services, etc). I suspect that FSA data will be roughly comparable.

 We’ll hold on to a larger percentage of this pot than competitors, and it’s because our quality is higher. Sinha: The more street-dependent buy-side firms will allocate a larger percentage to research.

 I see a hollowing out of the middle, of the 35th person providing IBM coverage.

 Weild: Citigroup provides a whole host of products and services that the independent firms don’t equity derivatives, enormous sales trading, algorithmic trading (Citigroup bought Lava Trading not that long ago), securities lending, and Citigroup is the #1 underwriter of equities globally.

Citi has a great portfolio of services that go beyond simply research and that gets reflected in commission payments.

Sinha: There is aligning of consumption with spend Spelling: We have a discussion with client about what resources we can commit to them; what % of payment pool should be sent to them.

Audience Question: What threats can you make?

I had a client say, “Show us what you’re giving us. If you don’t have that, how can you tell us what you’re going to take away?” We have 3000 accounts.

 There were 4 contacts at one particular account who were heavy users of our research. They were the people we needed to upsell.

Tiers are binary: you turn it on or off. If you want research to be a profit center, how do you do that?

Saumya: How often is there a mismatch of clients who are dramatically underpaying? One of our clients asks, ‘What is the research product?’

 Lessing: We don’t talk about resources cost in dollars per hour. We talk about where the client ranks with us, and say we believe you’re underpaying.

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