Dirk Lever, AltaCorp Capital Inc.
We Know What You Want
Every company wants research coverage, and this is very understandable. Research coverage helps to spread your story, find new investors and facilitate trade between those wanting to buy and those wanting to sell (and hopefully the buyers outnumber the sellers). And we know every company wants to be a “Buy”, though in reality that is impossible, if analysts are to have any credibility. Imagine going into a store looking for a new stove, and the salesman says, “They are all the best!” I bet you would go to another store.
Do You Know What We Need?
The brokerage industry has changed, and drastically. Costs have increased, especially with respect to technology; I’ll address this later. But let’s just consider the cost of research coverage of your firm alone. Without getting into too much nitty-gritty on overheads, computer systems and data support, assume it costs a brokerage firm on average about $100,000 per year to maintain coverage of your company. I suspect it is actually more, but this is a nice round number.
Trading for Fractions of a Penny in a High Stakes Technology Game
On the trade front, the brokerage industry has transformed in a staggering way. Trade of ‘blocks’ has decreased significantly; in its place is now the growing world of electronic trading. And there is not just one stock exchange; now there are many ‘venues’ where trade can occur. Tracking them simultaneously (for reasons of simple arbitrage) is a staggering task requiring complex computer systems and algorithms. And consider that trade is now effectively instantaneous; two orders will rarely ‘match’ instantaneously. Have you heard about ‘High Frequency Trading’ (HFTs)? HFTs effectively look for arbitrage opportunities across venues (either mismatched buy/sell order flows or trades that could indicate larger volumes to follow) and trade rebate opportunities paid by the exchanges in order to stimulate liquidity in the market. And brokerage firms need to protect their clients’ interests from the HFTs, so there is a technological arms race raging at the millisecond level – arbitrage occurring faster than you can blink. On top of this, trade commissions on electronic trading have literally cratered; some firms are even offering trade for little or no commissions just to get access to the ‘flow’, and block trade commissions have trended down as well. Trade actually results in fees to various third parties, including the venue operators. The trade margins can be extremely skinny, so volumes matter.
Also consider that many institutional clients expect the brokerage firms to put up capital in order to facilitate their trade order; that is, to buy or sell the security before another side to the trade is found. The traders that do this, liability traders, have the high stress job of ensuring they do not lose money on the trade while they ‘take on’ the liability.
By the time the trade revenues and costs are tallied, the bottom line for many firms is that they are happy to ‘break even’ on trade operations. In fact, some would love to break even.
Financings and Advisory
The scramble to be involved in a financing, equity and debt, is palpable. The reason is the fees. However, bought deals are another form of potential margin squeeze, as the dealers effectively ‘buy the deal’ (they own it) then must turn around and sell the deal out in order to gain the profit. Some deals go sour and nobody is happy. It happens – but on average, the fees mean profits.
And Advisory work (often mergers and acquisitions) involves even fewer dealers. You get the picture – the competition is fierce. Let’s face it, dealers will fish where the fish are; they will not drop down nets that they know come up empty. Some industries may just not offer enough overall business for more than one or two analysts at most.
Independent Research and Commission Sharing Agreements
Some research analysts have decided to go solo and have no affiliation at all with any broker dealer. How do they get paid? Either buy-side institutions cut them a check directly for the services, or pay them through ‘soft dollar trade’ arrangements. Soft dollar trades (or Commission Sharing Agreements) are instances where a portion of the commissions paid to the firm executing the trade is directed by the buy-side institution to be paid to the independent researcher (and in today’s world, even to other brokers’ research departments). Some buy-side institutions have decide that they want to consolidate the number of brokers with which they will trade, and now pay the rest of the Street for its research by way of commission sharing agreements. In Europe this is significant, and the practice is coming to North America. The importance of ‘who trades your stock’ may soon be moot.
It Is Not Personal, It Is Business
In a recession, such as the one the investment industry is undergoing, analysts get culled, coverage gets dropped and expectations rise when deals actually occur. Trade volumes drop, deal flow shrinks and just getting paid is a scramble. Understand the other side of the coin when expecting research coverage – the dealers need to profit or they are forced to move elsewhere. And research is not a social service, so if you do get research, also understand that it needs to be independent. Other than that, it is business as usual!
Dirk Lever is Managing Director, Institutional Equity Research, AltaCorp Capital Inc.