Boosting the research environment

Ten years ago, two sell-side stock reports from two of the main brokerage houses were found to be not just similar but word-for-word identical. Egregious as this plagiarism was, it was not noticed immediately. With so many analyst reports focused on such a narrow range of factors, maybe nobody expected anything original.

“The way in which the research in investment banks functioned was that analysts were there to generate trade,” says Jennifer Walmsley, manager of corporate governance and engagement at Hermes. “Research was geared towards short-term ideas and a lot of the research was very similar from house to house.”

Walmsley says that even five years ago, the notion of a brokerage issuing research that examined anything beyond an 18 month or possibly two-year time horizon was risible.

Thanks to a number of different groups and initiatives, this is no longer the case.

Credit is largely due to the Enhanced Analytics Initiative (EIA), a group of asset owners and managers who have made a commitment to allocating at least 5% of their brokerage commissions to the houses that produce the best research on what the EAI terms ‘extra-financial issues’.

The EAI was set up two and a half years ago with the idea that a financial commitment to such research providers should create an environment in which it is easier for analysts to produce innovative research. The amount of money involved is far from derisory: EAI members currently control €1.8trn ($2.2trn), and their allocation to the brokerage houses is unlikely to be limited to the 5%.

Starting with an original baseline evaluation in December 2004, the EAI has updates its list of recommended research providers every six months, based on an evaluation of current available research by independent consultancy OnValues. This consultancy looks at work submitted to it by EAI members, rather than attempting a comprehensive survey of the market, although it could be argued that such a broad swathe of asset managers and owners probably see all relevant research.

What makes that research relevant? The EAI is not interested per se in socially responsible investing (SRI) if that means looking at ethical issues and excluding companies on the basis of their failure to live up to particular moral standards. Instead, they talk about extra-financial issues, or intangibles.

These can be described as fundamentals that have the potential to impact on a company’s financial performance or reputation in a material way, yet are generally not part of traditional fundamental analysis. This is frequently because their impact on the bottom line is unlikely to be reflected in the share price over the traditionally short horizon of financial analysis.

Extra-financial issues typically include climate change, corporate governance, employment standards, human resources, executive remuneration, environmental and social areas, and reputation risk. They may be specific to a company, an industry or cut across several industry-groups.

The key point is that they are long-term factors in driving a company’s share price; for investors with a longer-term investment horizon - such as pension funds - or even those that think in terms of creating a general investment environment where short-term interests do not necessarily override long term interests, this is good news.

“The EAI raised awareness that there are investors out there looking at the long term,” says Walmsley. “That’s absolutely key.”

The EAI’s self-declared aim is to become redundant, as extra financial research becomes integrated into the mainstream. Although they may have moved closer to this goal recently, there is still some way to go.

The most recent evaluation names 11 research providers: Bernstein, CA Cheuvreux, Citigroup, CLSA, Deutsche Bank, Goldman Sachs, Innovest, Morgan Stanley, Oddo Securities, Société Générale, UBS. The first study had looked over a period of 18 months, rather than six months, but found just seven worthy of recommendation. The following half year provided just four brokers producing sufficiently interesting work.

“This latest evaluation demonstrates a growing capacity among research providers to consider a broader range of extra-financial analysis,” commented Ivo Knoepfel, managing director of onValues. “Over the course of the last two years we have also observed extra-financial issues being considered by other research functions, beyond specialist or sector teams. While there has been a further refinement of models to integrate EFIs into investment valuations, we believe a key challenge going forward will be the wider application of these methodologies.”

There seems to be a core group of research providers - perhaps as many as 20 - with a further 10 or 15 on the fringes. On the fringes are firms who simply happen to employ innovative analysts, but some of the core have taken very deliberate policy decisions to concentrate on this style of research.

Goldman Sachs is probably a leader in this field. A spokesperson explained that the initial impetus came from a commission from the UN Environmental Programme Finance Initiative (UNEPFI) in 2003 to look at how environmental issues could impact on financials. “We saw immense amounts of interest from clients, so we have continued to cover these issues,” explains the spokesperson.

Commitment to integrating SRI research into mainstream research led to Goldman Sachs’s announcement in 2006 that it was taking an equity stake in external research provider Asset4. The Swiss-based company analyses a large universe of companies on a range of criteria, coming up with quantitative measures for sustainability. The figures can be used to feed into either mainstream or specialist research.

The topics covered by this research can be extraordinarily varied. Climate change in various forms is now much more comprehensively covered, having been given an enormous boost by the Stern report in the UK, an increasing scientific consensus that it is an issue, and almost certainly a man-made one, and the introduction of the EU carbon emissions trading scheme.

Among the ramifications of climate change, clean technology companies are growing and inspiring innovative research. It is a far cry from the story told by Peter Mikhailis, head of SRI at Morley Fund Management, of the sell-side response some years ago to queries about their views on climate change: “Do you mean the political climate or the economic climate?”

Nobody asks that any more, but there are still areas that the sell-side continues to ignore or at least fail to cover sufficiently. “I still think there is a huge market inefficiency,” says Mikhailis. He cites the example of REACH, the EU directive on the registrating, evaluation and authorisation of chemicals, which is due to come into force on 1 June 2007 after three years of negotiation. According to the European Commission, under the directive, “the innovative capability and competitiveness of the EU chemicals industry should be enhanced”. And yet, says Mikhailis, many sell-side analysts have never heard of it.

Apart from EU regulation affecting the chemicals industry, where is sell-side research letting opportunities slip?

“There is not much coverage of human capital related issues,” according to Walmsley. While this might include HR policy and its effects on long-term profitability (and there are attempts to quantify this), Walmsley is referring to issues such as the effects of M&A; she would like to see more work done on the cultural challenges of merging workforces, which is often where value is destroyed in such a transaction.

Of course, there are reasons why there is a dearth of such research: for a start, there is a systemic issue, in that analysts working for any investment bank involved in a transaction will be precluded from performing the research. They may also feel a more general taboo against doing research that might show that many M&As are not value-adding in the longer term, as it might seem to discourage a line of business for their own firm.

Although its influence has been much greater than might have been expected two years ago, the EAI is not the only driver of the recent increase in awareness of extra-financial and responsible investment issues. The Marathon Club (see article on page 6) exists to address how the financial industry might overcome the apparent barriers to long-term investing, and recently brought out a guidance note to that effect.

Many asset owners and managers have signed up to the UN Principles of Responsible Investing; although this may initially have been the equivalent of declaring oneself in favour of motherhood and apple pie, it will shortly be incumbent on the signatories to declare how closely they are adhering to these principles.

In the UK, the annual Thomson/Extel analyst survey has in recent years included a section sponsored by the UK Social Investment Forum, rating SRI analysts. All of these initiatives have raised awareness of the issues.

The more awareness there is of these issues, the more asset managers are asking for the research, the more research the sell-side will continue to provide.