The weakened state of the UK’s capital, and specifically equity, markets prompted the proposed 2023 Edinburgh Reforms from the government. De-equitisation of UK pension portfolios and Brexit are factors said to have reduced liquidity and interest in UK equities. The ensuing lower values prompted the de-listing of some companies that have headed for the more attractive stock markets, such as the more highly rated US market. To what extent though has the reduced availability of investment research contributed to the decline, lower multiples and what can be done? Will the teenage scribblers, as described by Nigel Lawson, have their day again?
Investment research produced by investment banks and stockbrokers was for many years paid for in a bundled fashion, through commissions generated when shares were traded. The loss-leading cost of all the ‘teenage scribblers’ could be justified by the commission flow. Research was a prerequisite for a relationship with an investor and a corporate finance tool. However, the lack of visibility as to how much value was attributed to research led many brokers to produce research on the same stocks and often of moderate quality. Unbundling and MiFID II, introduced across the EU (including the UK at that time) to address investor protection and competition concerns, changed all this and overnight it became evident how much investment managers thereafter would have to pay for research, with the result that the available funding plummeted. The research departments of investment banks and brokers were shrunk dramatically, along with output. The FCA says that consequently ‘over recent years there has been a significant drop in the level and quality of research coverage in the UK market.’ Interestingly, in the deeper, more buoyant and vibrant US market, brokers have not cut their Stateside research resources by nearly as much.
Research coverage of small and mid-cap stocks has always been challenged by the more limited returns and trading opportunities while corporate finance is an important component of a broker’s income. The economics of small and mid-cap research was badly impacted by unbundling. Although the growth of company sponsored research has helped to fill this gap, there is said to be too little information and opinion in this sector. A series of broker mergers in this segment underlined the pressures on profitability, speaking to a lack of corporate finance. The FCA recently changed the rules to allow bundled commission trading for companies with a market cap of less than £200m, with Europe enacting similar rule changes, but this move does not seem to have had much of an impact so far. The adverse trends are particularly evidenced in the healthcare sector, where low valuations of companies are making it more expensive and difficult for companies to raise money through equity issuance. Hence corporates are quitting in numbers for sunnier shores and new issues are a rare event.
Rachel Kent’s Investment Research, published in the middle of last year as a part of the Edinburgh Reform package, made suggestions to improve the provision of valued research. The report points to ‘a “virtuous circle,” with good research contributing to better valuations, which in turn encourages investors, leading to greater liquidity and increasing the overall attractiveness of the UK as a place to list.’
The specific recommendations included amending regulations to allow greater choice in how research is paid for, effectively diluting the unbundling rules; establishing a research platform ‘for the promotion, sourcing, and dissemination of research – in particular, in relation to smaller companies’; facilitation of greater access to investment research for retail investors, hence encouraging them to invest and provide liquidity; and harnessing universities to produce research and train investment analysts.
Research needs to be funded or paid for and will only be in demand if it provides value. The current payment mechanisms in place with large investors are an impediment which is unlikely to change easily, while the administrative burden of running a different approach for the UK, compared to Europe or the rest of the world, is an impediment. Company sponsored research is one source and levies could feasibly help establish the research platform. For the larger and more global investors, an approach which takes into account the practices in other markets is more likely to succeed. Greater flexibility in paying for investment research by institutions could increase their purchases, but we are unlikely to see a return to historic levels. Using universities to produce research and train investment analysts, however, potentially brings into prospect a new generation of teenage scribblers.