Are you fearful that your research report is not reliable?  Are you weary that the analysis in the report is biased?  Are you skeptical about the analyst’s true intention because he is working for a research house that is financed by a broking house?

These worries were the reason why independent research houses were created.  Independent equity research services have been available to Singapore investors for years.  These research houses were passionately conceived by entrepreneurs who saw opportunities in the ever increasing retail investor pool in the stock market.

Unfortunately, these companies are struggling to keep their heads above water as the actual demand for such research is not sufficiently high.  To survive, these firms had to resort to cost cutting measures – such as paying their analyst below market price or employ “cheap” analyst – which than further reduces demand.

Independent research houses argue that their existence is essential as they provide an alternative information source that is free from bias; since they are not employed by the brokers but by investors, their interest is aligned to the latter. 

But do reports produced by independent research houses really add value to the investor?  Are reports produced by non-independent research houses really biased?  If so, why do they continue to thrive?  We explore the possible answers in this article.

The Case Against The Non-Independent Analyst

Accusations of non-independent analyst working against the interest of investors are plentiful.  Accusations include analysis reports from analyst of investment bank contradicting the action of the bank (recommending “buy” while the bank was selling the shares); analysts of broking houses are consistently over optimistic on target prices of stocks to help their firm generate brokerage revenue; non-independent analysts consistently advocating “buy” calls to help increase the value of listed companies so that they can acquire insider information in return.

These accusations may not be all untrue in the past but capital market authorities – namely MAS (Monetary Authority of Singapore) and SGX (Singapore Exchange) – are now more vigilant than ever to ensure that the market is a fair trading ground for all investors and flouting the laws is now more difficult and also more “costly” compared to the past.

With such vigilant capital market authorities policing the market, value add from independent research houses providing “untainted” reports are therefore largely diminished.  But independent research houses may still provide investors better research analysis because they are paid directly by investors and not indirectly through the investment bank or brokering houses.

Interestingly, a research paper “Do Analysts at Independent Research Firms Make Better Earnings Forecasts?” by Jacob, Rock, and Webber (2003) concludes that

“(Our)… results indicate that forecasts from analysts employed by IBs (Investment Bank) are generally more accurate than forecasts from analysts employed by independent research firms. This is consistent with higher skill levels and better resources at IBs dominating any differential incentives vis-à-vis independent research firms.

Contrary to opinions expressed in the financial press, we also find that IB analysts are less optimistic in their earnings forecasts than analysts employed by independent research firms. Given the recent scrutiny IBs have undergone regarding their conflicts of interest, these results may be somewhat surprising.

We argue that some conflicts faced by investment banking analysts likewise apply to independent research analysts (e.g., the incentive to issue optimistically biased forecasts to gain access to better information). Further, some factors accentuate the incentives for independent research analysts to issue optimistic forecasts relative to IB analysts. Analysts employed by investment banks might have greater incentives to issue optimistic forecasts to get access to information. Hong and Kubik (2003) suggest that accurate forecasting and optimistic bias improve individual analysts’ career prospects.”

It’s the Investors’ Fault!

Ask the CEO of the independent research house why independent research houses are not thriving and he will probably tell you that investors are “spoilt” by the current system.  Since Singapore investors receive free research reports from their brokering houses, paying for research reports does not make economic sense – especially when the quality of reports from the independent research houses is poorer.

The result of the inability to garner sufficient investor support means that independent research houses are unable to secure good analysts and also sufficient quality information which leads to further deterioration of report quality.

The answer to arresting this vicious cycle seems simple. Educate investors that they are indirectly paying for research in reality when they receive “free” reports from their brokers and such reports may not be written in their best interest.  Instead, the investors can align analysts’ interest to that of the investor if he pays fees directly to the independent analysts instead.

Alas, in truth, investors are not stupid.  Investors are aware that the free reports they receive are financed by the broking houses they trade with.  Investors are also aware of the caveats that come with these reports.  But why than do they still support such practice?  Why not support the independent research houses instead?

The answer lies in simple economic analysis.  The investor is really not interested about righteousness of the independent analysts or the creators of such institutes; his only interest is to make economic profit from his investments.  The cost of acquiring such research reports must therefore be lower than the benefits derived from using the report for the investor to be willing to purchase.  In other words, the investor is only interested if the reports can make money.

If reports from brokering houses are nonsensically written just to attract trade volume and investors makes more losses than gains from relaying on these reports, than investors will overtime stop relying on such reports and trade less often.  The loss of income would lead to the brokering house to either beef up the quality of the reports or face the ultimate fate of liquidation.  From this viewpoint, the indirect research cost – incurred only when investors trade through the broker – becomes a variable cost, and therefore a form of real option, to the investor.  This real option arrangement also ensures a reasonable quality of work from the non-independent research house is produced.

On the other hand, independent research house charge an annual membership fees for investors to have access to their research materials.  This becomes a fixed cost once the investors choose to undertake.  Unless the benefit (profits) from using the report over the year outweighs the cost, investors will not be willing to pay for such services.  Furthermore, stock investment is very risky and unless independent research houses can produce “sure win” reports to investors, they will probably not be able to charge high prices for their annual membership.  This than creates the vicious cycle mentioned above.

Get Listed Company to Pay for Research!

To survive, independent research houses developed a great idea – get listed companies to pay for their research.

The proposition is interesting.  If listed company can incur the bonding cost (as defined in agency theory) by undertaking external audit, why can’t they volunteer to pay an independent body to do a research report on them to verify their value?  Isn’t volunteering to be researched on a good signal of value?  The case for paid research had even garnered the support of the authorities who subsequently conceived the MAS/SGX research scheme.

While the argument is intuitive, it does have its weakness. When an audit firm is engaged to conduct an audit on a firm, it has access to all the information it requires to discharge its duties.  Any resistance from the audited firm to provide the required information would mean a qualified report from the auditor – which would lead to much corporate governance scrutiny after.

Paid research, on the other hand, does not enjoy such a privilege. Independent analysts only have access to public information – like every other analyst – even though they are engaged by the firm.  Furthermore, executives of the firm can always rely on the MAS insider trading and public disclosure of information rules as an excuse to hide important information from the analyst.  This means that the quality of paid research is no better than the ones provided by any other analyst.

Investors would also question the level of independence in this case.  If the firm is paying the research house to do research, how can the analyst be independent?  This suspicion is further heightened by the fact that paid research can form a substantial part of the research houses’ revenue and profit.

Again, we quote the research findings of Jacob, Rock, and Webber (2003):

“Our study should be of interest to regulators and investors. Regulators are attempting to promote research from independent research firms because analysts at these firms are allegedly less subject to conflicts of interests than analysts at IBs. They should be aware, however, that independent research firms are not immune to conflicts of interest and might employ less qualified analysts and equip them with fewer resources to conduct their research. This scenario suggests a possible cost in terms of the quality of the research.

It might be of interest to investors to know that although prior research (e.g., Dugar and Nathan 1995) documents biases in IB analysts’ forecasts of the earnings for firms that are clients, these biases are not as pronounced when comparing IB analysts to independent research firm analysts generally. Additionally, investors might benefit from knowing that IB analyst forecasts tend to be more accurate and less optimistic.”

Fate of Independent Research Is Still Uncertain…

So what will happen to independent research houses?  At this juncture it is hard to tell but their future seems to be bleak.  At present, some independent houses are still supported by the passion and righteousness of the owners and analysts but at the back of their mind, survival and wealth will continue to remind them about their true goals. Even the most heroic of all man cannot escape the truth of life and assess their cost and benefit rationally.

But we do have one fear. As market forces put these independent research houses through the slow and painful torture of the vicious cycle, independent research houses may switch their strategy to investor protection out of desperation.  The combination of the continued circulation of low quality research reports together with the possibility of companies paying for research to avoid unnecessary investor protection debates will inevitably dent the reputation of any financial hub.  Proper intervention by the authorities when tell tale signs of trouble shows should prevent any unnecessary disruption to the development of our financial hub.