Cross-posted on the Gridstone Blog.
Candace Browning, Head of Research at Merrill Lynch posted an open letter last week that talked about the “Napsterization” of sell-side research, justifying why Merrill Lynch would have to take control of the distribution of their research.
As messages go, “Napsterization of Research” is as sticky as they come. Drawing an analogy with digital music (and film) is apt, but there are key differences as well. Understanding those differences is important to be able to see where the sell-side research puck is headed.
Both music and research are information products. For both, however, there is more to the experience than can be digitized. In music the “augmentation” (like concerts) is minor. But in research there are many aspects of the value that the firm provides – one-on-one consultations, management meetings etc. – that cannot be digitized. The threat of being napsterized into oblivion is therefore considerably less in the case of research than in music.
However, the cost of piracy or unauthorized use is higher in research. Piracy in music results in a loss of revenue from consumers who would have bought legal music in the absence of readily available illegal music. In research, unauthorized use results in not just loss of revenue of the abovementioned kind, it also reduces the value of the product in the hands of legal users. Widely distributed insight is already priced into the market and is therefore not actionable.
The customers for music are individual consumers. Research clients are investors and asset managers of various sizes. This difference is key to how unauthorized use is tackled. Its largest customer holds no power over a music label. For a sell-side firm, on the other hand, a large mutual fund or an actively trading hedge fund could be paying a significant percentage of total fees. So while the RIAA can sue individuals for pirating music to make an example out of them, Wall Street must walk on egg shells while they try to take back control of their IP.
In this context, I foresee a greater use of technology to discourage sharing and unauthorized use. Watermarking will be used more extensively. Use of alternative media types that are less reproducible, like podcasts behind authenticated websites is another interesting possibility. The tricky part is to find ways to discourage unauthorized use while not making it harder for authorized paying clients. But it is not completely hopeless. If the digital music industry led by Apple has been able to pull it off with complex, user-unfriendly DRMs (Digital Rights Management), there is no reason sell-side can’t.
Pricing is perhaps where the differences are the greatest. Music pricing, for the most part, is clean and simple. $10-15 per album and $0.99 per song on iTunes. Films have a little more sophistication in their pricing. They use what is called “windowing” – theatrical release, followed by DVD and pay-per-view, followed by cable. Value extraction is higher per viewer in the earlier windows and lower in the later windows.
Sell-side attempts to “value price” research. I say attempts to be because if there is one thing that is begging to be fixed in research, it is pricing. The days when commissions on trades were considered a good measure of the value of research are dead and gone. But independent of how research is priced, there is no question that the value of research in the hands of an investor drops off sharply with time. It actually drops off much, much faster than in films. So even while research pricing evolves, there is still every reason to have and impose strict windowing policies on the distribution of research. Average commissions attributable to research may be falling in the industry, but why must you lower the value of research to your best clients by releasing it to non-clients too early?
For people who have gotten over the Wall Street excesses of the late nineties, it is clear that a healthy, growing sell-side research is necessary for the efficient functioning of the investment management industry. Disciplined windowing and controlling unauthorized use of research are much needed measures in restoring sell-side to health. Merrill’s moves are welcome and necessary.
A well intentioned article. IP protection indeed translates into bottomline any day and is necessary to safeguard the exclusivity of insights drawn by Sell-side initiatives.
But taken in isolation, how exclusive are these insights itself – especially when one-on-one consultations and management meetings are either forward looking statements or just plain PR campaigns ( hence not taken at face value by investors, unless are of the nature of insider information itself which is downright illegal anyway)as are becoming less and less relevant ?
Don’t you think in these days of open source access ( we have investopedias together with free research sites available)to undifferentiated high quality research that is freely available, privity of information is at best ephemeral ?
After all this, within a given broad parameter of Fund/Investor focus (of say stocks with a market cap range and in sectors of choice), random theory still holds very, very good !
What business is sell side research exactly in?
1) Providing insights
2) Providing plain vanilla trading platform?
3) Something totally different?
There is another as aspect to the DRM debate.. there have been bands which have used free distribution of music to drive select sales and music tour tickets. You might say that this is bad for the music industry at the CD level, true….if the market does not need them they should become extinct. (Painful)
Now, as I understand the true value of sell side is delivered when someone calls the analyst to hear out what he says. The fact that sell side is destroying itself on working with useless preresult/post result updates for primarily delivering useless information is somethign to take note off.
I would think that spreading the insight everywhere and ensuring phone calls (the analyst is the differentiator right?)
is the way to go. You cannot prohibit information flow.
ML did 19 % vs 16% of MSCI? Oh c’mon they should do better if they want ot be in the business. How much did their own trading desk do? Duping investors 😀
Interesting thought. If music bands have varied business models some of which depend upon concerts for revenue, while music downloads are just promotion, perhaps the sell-side industry might also have a variety of different business models. IMO, their challenge is that the cost of research (mostly salaries) is so high, that they don’t have too many options when it comes to business models.
Never thought about this issue. Thank you for the post.
This trend actually bodes well for companies such as Gridstone, EVS, Copal etc.
As someone from buy side, I can confidently say that the quality of sell side research has gone down in a big way. I don’t think most sell side research departments can survive as independent research outfits. Markets are more mature now and no one really cares about the sell side research – sorry, sell side journalese.
It is just a matter of time before they become permanently irrelevant. All this ML talk is just a ploy to make their research appear valuable.