Management theories fall in and out of fashion but one that has stood the test of time is Professor Clayton Christensen’s Innovator’s Dilemma. His description of spirited disruptors that successfully take on large incumbents, with seemingly inferior products that improve over time, has been applied to many industries ranging from tech to auto manufacturing.
But can his theories be applied to the transformational changes we are now seeing in the equity research business and do his books give us clues as to how these changes will develop over the next few years? This is, after all, an industry that has evolved in increments rather than changed outright over the decades.
The Research Mountain
The early days were simple. Equity brokers would phone their clients to tell them the stock price moves of the day, backed by a few backroom analysts drawing stock charts with slide-rules. Then in the 1980s, brokers would send one or two-page company research notes to their clients by post or fax machine. All of this made sense when it was paid for by fat share trading commissions.
But in the last decade, the broker research model has snowballed with the help of the internet. Every bank now has an enormous research department producing mountains of overlapping product. The research model has swelled and commoditised, but this has coincided with significant reductions in trading commissions.
And Christensen’s second book, the “Innovator’s Solution” – in many ways superior to the first as it summarises his basic theory in one chapter and then applies it to large and small firms alike – deals with this commoditisation process and explains how innovative disruption can upend this state of affairs. The read across to the equity research business, where the cost and regulatory changes are leading to the emergence of smaller new – entrant research firms, is obvious.
End of an Era
The research business is in the middle of its deflationary phase. The commodity research churned out by sell-side brokers, some of it good but much of it repetitive, has hit the wall of reduced commission income to pay for it as well as cost pressures on both the sell-side and the fund manager buy-side. The regulatory changes introduced by MiFID II – specifically commission unbundling which forces the issue by making consumers directly pay for the research product – are merely a catalyst.
Product commoditisation is core to the industry shifts described by Christensen in the “Innovator’s Solution,” and he discusses this in terms of a stark comparison between the incumbents’ reliance on “Sustaining Innovation” and the “Disruptive Innovations” brought in by new entrants.
Incumbents sustain their products with progressive improvements that respond to existing customer needs but eventually hit a wall as they become commoditised. Disruptors innovate by implementing products that are “cheaper, simple, smaller and more convenient to use,” initially appealing to a new set of customers but eventually succeeding in breaking the commoditised market.
Anticipate the Hockey Puck
The buy-side has been aware for years that there is too much repetitive research product, but this only became an issue once changing regulations forced them to pay for it themselves. Sell-side firms are sweating over high costs and reduced returns but are struggling to change the broker research model that has served them so well over a generation. And this is where the new entrant research firms come in, in a move well anticipated by Christensen’s ideas.
Christensen’s theory is involved, but his language is clear:
“Disruption works because it is much easier to beat competitors when they are motivated to flee rather than fight.”
This phrase is core to the new research firms’ business models. Sell-side incumbents are stuck with their high-cost products targeting top-tier fund managers. New research firms push streamlined, data-led primary research targeting hedge funds and the alternative buy-side in areas that high-cost incumbents are unwilling, or unable, to focus on.
“The critical unit of analysis is the circumstance and not the customer.”
Buy-side cost pressures and MiFID II are the circumstances, and the new research firms’ cheaper and streamlined products hit the spot.
“Skate not to where the puck presently is, but to where it is going to be.”
New firms are flexible and sensitive to the buy-side’s evolving needs and values. They have a less entrenched sense of what they think their core competencies are and can be quick to anticipate and move with the times.
“Managers need to watch vigilantly in the right places to spot trends as they begin because the processes of commoditisation and de-commoditisation both begin at the periphery, not the core.”
Commoditisation has been eating into the research industry for years – buy-siders are inundated daily with thousands of reports. Starting from a clean slate, new research firms can side-step the myriad daily commentaries, results notes and re-hashing of company statements, allowing them to focus on a more direct product that their client really needs.
Christensen spends a lot of time talking about modular structures, and new research firms are a case in point, able to bring in outside expertise when needed in a way that incumbents’ inflexible structures do not allow. Their product may be cheaper but the ability to be modular, incorporate non-core competencies, and tailor output to the clients needs de-commoditises and differentiates their offering.
Finding a Niche
But, however attractive this all sounds for the new research firms, they need to take care. “The Innovator’s Solution” actually attempts to provide a how-to guide for large incumbents to become disruptors themselves.
Equity market practitioners know that the emergence of new generation research firms is not a one-way trade. Large investment banks may fill the role of the incumbent, but they do have large amounts of capital and pools of high-quality people that can be brought to bear to execute change themselves.
Maybe the real lesson that the equity research business can learn from Christensen’s ideas is that the commoditisation phase of the industry is ending and new research firms have gained a foothold that allows them to build up market share while improving their products. This will change the shape of the industry, forcing some large investment banks to specialise and others to retreat.
The industry will become much more competitive, and both new research firms and incumbent sell-siders will need to carve out their respective niches in a much more fragmented industry.