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Strategic Finance

What have brokers ever done for us?

Monday, 27 November 2006

Keiron Root examines how far extra-financial issues are being taken into consideration when assessing an organisation's future prospects.

With the possible exception of corporate banking services, the relationship between a quoted company and the broking community can be the most fraught and the most equivocal of any of the professional, commercial links it maintains. It can also be the most expensive, even where no fees actually change hands, because ultimately the published view of a company collectively among the major broking houses and arising from individual research will have a material impact on its performance, because of the way in which the market views its shares.

Indeed, it is becoming increasingly common for boards to openly ask what analysts actually do to earn their high remuneration, when they consistently ignore key factors relating to a company's future prospects simply because they do not appear on its balance sheet. There is still too much emphasis on number-crunching and analysis of past figures and not enough consideration of extra-financial issues (EFIs) that are likely to have a material impact on a company's future performance.

At the beginning of 2005, the Enhanced Analytics Initiative (EAI) published the results of an evaluation of the quality and effectiveness research by brokers participating in its programme. The EAI is a group of European institutional investors and investment funds that encourages sell-side researchers to analyse material extra-financial and intangible issues as part of their research process. Its members seek to reinforce this by agreeing to allocate a minimum of five per cent of their broker commissions to those institutions that best provide this type of information, which represented a total of some g4m to g5m during 2005.

The survey contacted 31 broking houses, 21 of which provided information for the survey. This data was then assessed by a specialist research house, onValues. The detailed evaluation covered both the quality and coverage of their past research output and their commitments for 2005. The key findings of the survey identified the following trends:

Changes in regulatory frameworks - including accounting, reporting, litigation trends - are an emerging topic of research by brokers;
Given its importance, corporate governance is not a highly researched topic and only three of the top ten brokers systematically cover this issue;
Given their importance for company value creation, it is surprising that issues such as intellectual capital management and human capital management - including remuneration systems and HR management - are comparatively under-researched;
The introduction of the European emissions trading scheme has led to a large number of research outputs, some of them with repetitive insights, which may indicate the potential for the EFI-equivalent of 'me too' coverage - as currently happens with financial statements. This, the report says, "would not be a welcome development";
Several brokers are focusing their EFI analysis on the sector or issue level and have not yet developed frameworks to integrate this kind of research in company and stock analysis;
Some brokers have generated new insights by teaming up with strategic consultants, external experts or academics, or by forming internal teams of analysts from different sector teams;
Brokers have been relatively quick in picking up on some emerging geopolitical risk issues, such as terrorism, but the analysis is not comprehensive yet;
Extra-financial issues in the context of corporate restructurings/M&As have not been a topic of systematic research yet;
Some issues which are particularly important in emerging countries, and which can destroy company reputation and brand value, such as contractors and supply chain risks or bribery and corruption, are practically missing from the radar screens of brokers;
Some brokers have started to experiment with methods such as structured stakeholder consultations or scenario-based trend analysis to better capture impacts of EFIs.

Peter Moon, Chief Investment Officer of Universities Superannuation Scheme, one of the founder members of the EAI, observes: "The ad-hoc approach taken so far by many brokers has resulted in a rather patchy coverage of different extra-financial issues, sectors and companies. EAI is convinced that, by providing the right incentives, it can support brokers in taking a more systematic approach to this type of research."

Roderick Munsters, Chief Investment Officer of PGGM, another initiative founder member, adds: "EAI is confident that the quality and coverage of extra-financial issues will improve considerably in the near future, but we know this depends on additional clients sending a clear signal to brokers about what they want. The most effective way for funds and their managers to do this is to join EAI."

The report itself states: "Based on the encouraging response to its call and on the observed developments in the sell-side research field, the EAI would like to encourage brokers to cover the effect of changing regulatory frameworks well ahead of their implementation, before the information has been integrated in the market's price building mechanism: not to shy away from issues which are difficult to quantify, such as long-term risks or impacts on intangible value (e.g. brands or company reputation) or sensitive to comment on (e.g. chief executive remuneration or M&As); to differentiate more clearly between different time-horizons of causes and effects. Long-term trends, such as changing demographics or increasing environmental pressures, for example, can have short, mid and long-term effects on company value. It is therefore important to distinguish and declare different time-horizons used in research."

There is also a call for broking houses to "research new issues and develop innovative methodological approaches, thereby taking a lead in further developing the extra-financial research agenda and to take a lead in developing better frameworks to integrate extra-financial research in company and stock analysis, thereby enhancing the value of research for better investment decisions".One of the more significant findings of the EAI survey, from the point of view of the companies these brokers are analysing, is that it has discerned five distinct levels of commitment towards extra-financial issue research:

Phase one - ad-hoc, client driven

Where the broker is reactive and will look at EFIs only if important clients ask for this work to be done.

Phase two - ad-hoc plus in-house champions

Where the research is still mainly client driven and, therefore, of an ad-hoc/patchy character. At the same time, though, in-house champions appear, contributing an increased level of continuity and in-house thinking.

Phase three - low-hanging fruits

Where the broker acknowledges at an institutional level that coverage of EFIs offers some interesting business opportunities. But the research is done in a rather opportunistic way, focusing on low-hanging fruits, i.e. covering well-accepted topics that require a low amount of investment.

Phase four - institutional commitment

Where the institution starts acknowledging EFIs as being of strategic importance, at least in some key sectors. The broker considers extra-financial research as a differentiator and as an important business opportunity, and commits sizeable investments to improve its coverage of selected sectors and issues.

Phase five - core business strategy

Where the institution puts extra-financial research at the core of its business strategy. This is reflected in a high level of investment and quality research output and research on EFIs is fully integrated in financial analysis.

Needless to say, although the EAI survey found evidence of major brokerage houses moving up this scale, with several making the transition from phase three to phase four, none have yet made it as far as phase five. Indeed, the report confirms: "The evaluation of brokers' commitment to produce relevant research in 2005 shows that several incremental improvements are planned, but no major leaps.

"As many brokers are planning major investments in the field, EAI is confident, though, that the quality and coverage of EFI will improve considerably in the near future."

However, the grouping also acknowledges that its European focus is a limiting factor, adding: "This depends on additional clients sending a clear signal that this is what is wanted. In particular, the presence of a US asset owner would have a significant impact on global brokers."

Keiron Root has been a financial journalist for 20 years, contributing to a wide range of specialist financial and investment publications plus the financial sections of the national press. He is Consulting Editor of Treasury Management International, Editor of What Investment Trust and Editor-in-Chief of What Investment magazines.