Third Bridge Views: Equity Research, the Short History: Regulation, Deregulation, Crises and MiFID II

In this edition of views from our executive team, Third Bridge co-founder and managing director Joshua Maxey discusses some of the main themes impacting the equity research sector

Between 334-331 BC, Alexander the Great conquered the Persian Empire. Then, in 30 BC, the Romans conquered Egypt. At the beginning of the 19th century, Napoleon Bonaparte also set out to change the world and rule an empire. Throughout history, decisions were made many times on guts, for revenge or for ego. But nonetheless, many of the great wars seen in history came to be after the experts of the time put together some sort of report or analysis saying that investing in this or that war will make someone or some country rich and powerful. So whether it was a macro overview of a region and its potential, or the micro analysis of whether it made sense to invest in a company, equity research has been around, in some form or other, for a long time.

Fast forward just a bit, and the establishment of a plethora of companies in the 18-19th century paved the way for what equity research is today. 

Equity research is closely tied in with the fate of financial markets. When markets move, research will closely follow suit. 

The Need for Information

One of the main contributors to bubbles in markets is a lack of information. This occurs especially when the general public becomes heavily invested in a market without a proper understanding of that market’s fundamentals. Stocks being misaligned to value, but a great interest from the public nonetheless, led to significant repercussions – in the case of the South Sea Company, not only did a significant number of individuals fall into complete ruin, but the British economy was also greatly hit. A failure to grasp what the underlying assets and their intrinsic value were spawned such events as the Tulip Crisis, the Dot-Com bubble and, more recently, the financial crisis of 2007/2008. 

Had there been relevant information available to those looking to invest, one could argue that those crises could have been avoided. (Although it’s always hard to fight the basic human instinct of wanting to make a “quick buck.”). This is where equity research comes in. Its main role is to provide information to markets that could otherwise suffer from stocks’ values being misrepresented. An analyst will analyse a stock in depth, by looking at a company, its competitors, and the markets it is active in, so that investors don’t have to. 

However, it’s not as clear-cut as it may seem. Over the years, the alternation of bear and bull markets has left room for people to both spot the opportunities for profit and indulge in excesses. Whether one likes it or not, markets can be fussy and can lead to extreme decisions that, in turn, result in massive losses. Or, indisputably, significant gains. But when we’re talking about losses, investors are never ready to own up to their responsibility. Which may be what put a dent in the reputation of equity research.

But it’s rarely the analysts that drive the mad rush to get a piece of whatever is the hot pie du jour. The excesses mentioned earlier become a lot more apparent in the bull markets – and having the benefit of hindsight. And then there’s always another fact. Many investors prefer to focus on the positives when it comes to their investments – the so-called confirmation bias – rather than give the time of day to analysts that are more tone-neutral or flat-out reluctant. They also tend to be incentivised to not be contrarian – it’s not really worth sticking one’s neck out and falling outside consensus range.

And it doesn’t help that some analysts were actually championing certain stocks, especially since the banks they were associated with on the sell-side were working with those companies too. Although the actors are supposed to be on each side of a sturdy Chinese wall, practice has taught us that that is not always the case. 

And the Need for Regulation

And that’s where regulation comes into play. First, the Glass-Steagall Act of 1933, prohibited banks from being involved in both commercial and investment banking, as a response to the 1929 crash. The thinking behind it was that large banks would not be able to manipulate markets and then turn hefty profits. This gave birth to the US’ famous Securities and Exchange Commission (SEC), probably the most feared markets overseer in the world.

The UK established its Financial Services Authority (FSA) in 1985, just a year before Margaret Thatcher’s financial markets regulation overhaul – known as the Big Bang – which afforded UK financial firms to start properly competing with international ones. Up until Thatcher’s bold move, the London Stock Exchange (LSE) had a strict set of practices in place – from fixed minimum commissions to no foreigners accepted as members of the LSE.

The FSA was later dissolved in 2013 by then-Chancellor of the Exchequer George Osborne, but its role was split between two entities, one of which is today’s Financial Conduct Authority (FCA). The FCA is the one supervising equity research.

Enter Deregulation

As one would have it, critics have been gnawing at regulation for decades – and in some cases successfully. In 1986, in the US, the Fed set a cap of 5% of a commercial bank’s revenues that could come from investment banking, reinterpreting the Glass-Steagall Act. Just ten years later, that level was pushed to 25%. 

In 1999, during the Clinton administration, the Financial Services Modernisation Act completely overturned Glass-Steagall. Five years later, the SEC lowered the proportion of capital that investment banks had to hold in reserve. 

Meanwhile, in equity research, in order to ensure the integrity of recommendations made by analysts, former prosecutor Eliot Spitzer pushed rules that separated equity research from investment banking within the same bank.

Then 2008 came, and the world economy almost collapsed. 

Stepping in, the US administration passed the Dodd-Frank Act in 2010, the most significant financial services regulatory reform since the 1930s, aiming to stop the “too big to fail” financial institutions from aggressive practices with dramatic consequences. Last year, the Republican-led Congress voted on legislation which is set to roll back significant parts of Dodd-Frank.

Where We Are Now

2018 will be the year of MiFID II in equity research, and all actors will have to see through the changes needed or face significant problems. The sell-side will likely see dramatic changes that will only see the best analysts survive, as clients will no longer pay for packages that include research. Research will be a product in itself, priced as such. 

As the rest of world is tailoring its approach to MiFID II, equity research is set to see a much-welcomed turn towards quality, which we have championed for many years. And the push for transparency that the European directive has instilled will not only make the market more competitive, but it will also ensure the survival of the fittest. Which, in a competitive market, is definitely a good thing.