MiFID II and Research – What it means for Investor Relations

Continued market turbulence, dwindling research coverage, rising activism and falling returns are challenges many IRs will encounter in the UK market this year. Some, of course are already battling one or more of these. The impact of MiFID II on research is already being felt, as brokers react to reduced funding by cutting back on coverage. Even before MiFID II, the major investment banks had been rationalising coverage in recent years. Individual analysts are required to cover more companies, there is a greater focus on the larger stocks with significant trading volumes, and fewer sector specialists. While the ‘bulge bracket’ brokers are far from immune,  MiFID II seems to be having a disproportionate impact on small and medium sized brokers, and consequently the research coverage of the smaller, often less widely covered corporates is most at risk.

But does a further reduction in ‘free’ research coverage really matter?

Numerous institutional investor surveys demonstrate that many fund managers do not value or utilise much of the ‘free’ research they receive. The only category of research which is valued by anything close to a majority of FMs is in-depth, detailed reports, while the least valued category is analysts’ recommendations.  Yet within the investment banking model, analysts are always under pressure to focus on the latter, in the form of trading ideas, at the expense of the former.   Many large fund managers have invested in their own in-house analytical teams which provide a supposedly more independent viewpoint, although this too can be distorted by internal pressures.  We should not forget, however, that the experienced and knowledgeable sell side analyst adds value to the buy side not just through published research, but also in other ways (compliance permitting), as a sounding board for ideas, an ad-hoc commentator on market events and as a source of long-standing background knowledge of a company or sector.

Declining research can impact liquidity and valuations

Below the upper echelons of the buy and sell side, freely available research plays a more important role.  For the smaller fund managers, neither investing in their own in-house analysts, nor paying for research on the new basis may be economically viable.  While many smaller FMs already do their own hands-on due diligence on potential investments, identifying these opportunities may become more difficult without access to a wide pool of research.  This in turn may hamper their ability to add value through being focused and nimble relative to their larger and, some might say, index-hugging peers.

On the sell side, small and medium sized brokers cannot readily subsidise their research output with the diversity of income available to the large investment banks.   Some have built strong niche positions with specialist sector expertise and coverage, but this may be harder to sustain under the new regime.   Already some smaller brokers are retrenching, with cutbacks in research teams and published coverage.  For those smaller listed corporates which fall outside the focus of the major investment banks (and post MiFID this category may grow to include some FTSE350 stocks),  a decline in the quality and scope of research could mean a lower profile with investors, reduced liquidity and  depressed valuations.

 

No magic bullet

There are, of course, independent research firms who offer an alternative.  Some are paid by corporates directly to produce research reports for distribution to investors. Others have built their value proposition on exclusivity and are paid by a limited number of investor clients for privileged access to their ideas, while those corporates fortunate enough to be selected for positive coverage bask in the glow of their expertise. While both these models have been successful, neither offers a magic bullet for the under-researched corporate.  Paid research, however competent, will always lack the credibility of what is perceived to be the more ‘independent’ views of the investment banks.  And the rating agency model, whereby companies pay for their own credit ratings, exemplifies the inherent conflict.  One does not have to look very hard, especially post- credit crunch, to find companies which have defaulted holding multiple ‘A’ ratings from different agencies.   Of course the rating agencies and independent research firms are very clear about the need to manage conflicts, and it could be argued that a credit rating downgrade is potentially far more damaging than a ‘warts and all’ research note.  Nevertheless, whether ratings or research, if your business model is founded on golden eggs, it is hard (not to say foolhardy), to kill too many golden geese in the spirit of independence.

On the other hand, being scrutinised by an investor-financed research boutique may not benefit a company, if the analysis exposes weaknesses in the company’s strategy or highlights other undesirable features.   Given the expertise and reputation of the market leaders in this field, their reports are highly credible, and the corporate may have little or no leverage over the message, unless it is based on demonstrable errors.  Worse still if a piece of so-called ‘research’ produced by a third party is deliberately designed to damage perception and valuation, as part of a shorting strategy.

Activism becoming mainstream?

For any listed corporate, ensuring that the company’s ability to create value over the longer term is understood by the market is crucial. This is all the more important in today’s markets, when investor returns are being squeezed. While most corporates do not expect to be targeted by the growing number of the high profile activist firms, it is worth remembering that both activists and more conventional value investors are looking for ‘good companies not fully appreciated by the market at large’. The difference is the speed and degree of improvement that is envisaged – how far investors will go to narrow the discount.

Hitherto, the instigators of significant change at targeted companies have largely been dedicated activist investors.  However, the squeeze on returns is prompting conventional investors to become more demanding.  In 2015, one study suggests that more than half of activist activity in the UK market was ‘occasional activists’– conventional investors becoming more engaged to address specific issues and force change.  As dedicated activists raise the bar for shareholder engagement and fund managers come under pressure to maximise returns, this trend seems likely to continue.   Becoming the target of activism, whether ‘occasional’ or not, is seldom good for the company’s reputation or management’s credibility, as well as consuming a huge amount of management time and resource.

So what does this mean for Investor Relations? 

If the ultimate goal of investor relations is to ensure that the company is accurately valued by the market, then the structure and content of communication with the market are all the more crucial in today’s environment.   What really adds value? I’d highlight these three aspects of a robust IR strategy:

Articulating value creation

To paraphrase Harold Macmillan, key drivers of investor sentiment and valuation will not just be events,  but also ‘results, dear boy, results’. However, results are by their nature short term, and desirable investors are focused on longer term value creation. This should be the basis of communications with the market, through a well-articulated investment proposition.  A regular results presentation does not fulfil this role, unless it is embedded in a longer term strategic context with clear links to the creation of longer term value. The investment proposition must be aligned with corporate strategy,  and should dovetail with the broader corporate profile in the media and articulation of the company’s brand, CSR, and governance.

Taking control of the message

The investment proposition will be key  to a proactive, market focused IR strategy which builds investor confidence and understanding, rather than being driven solely by the reporting cycle.  Taking control of the message is not about dictating what independent commentators say, but making sure that the company’s narrative is clear, relevant, consistent and well presented.  Engaging with financial journalists and market opinion formers is also important, particularly where research coverage of the company is limited. Capital markets days, major investor conferences and sector or industry conferences are all important opportunities to shape the market’s perception of the business – but only if the story is clear, consistent and well presented.

Positive engagement

Whether or not a company feels it has adequate research coverage, it will be better placed if it has developed a climate of trust based on a genuine dialogue with analysts and investors.  Even those with a tangential interest in the company may influence opinion, so the wider the scope of the dialogue the better.  Given the continuous feedback loop (largely invisible to corporates)  between analysts, investors, market commentators and the media, the benefit of such goodwill extends far beyond individual relationships. Crucially, it will stand management in good stead if the company falls on hard times or encounters unwelcome activism. And of course, a healthy flow of questions and feedback from the market help IR and management to identify potential issues and concerns early, and to clarify and refine the company’s investment proposition.

Finally

The IR’s role is to ensure that quality and value are recognised, regardless of short term turbulence. As the old market dynamics shift and new interfaces between capital and companies are created, the strategic value of proactive, engaged investor relations in making this happen can only increase.

May 2016

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