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EQUITY RESEARCHThe role of equity research is to provide information to the market. An efficient market relies on information: a lack of information creates inefficiencies that result in stocks being misrepresented (over or undervalued). Analysts use their expertise and spend countless hours analyzing a stock, its industry and peer group to provide earnings and valuation estimates. Equity research is valuable because it fills information gaps so that each individual investor does not need to analyze every stock.Equity research analysts conduct financial statement analysis and build financial models to derive a company's proper valuation. Ideally, research analysts must be as objective as possible, however different market, economic, and political influences can adversely affect equity research. EQUITY RESEARCH IN THE MARKETIn every bull market there are excesses that become apparent only in the bear market that follows. Each age has its mania that distorts the normal functioning of the market. Hedge Funds, Private Equity Funds, and Investment Banks can all get caught up in the excitement. In the rush to make money, rationality is the first casualty. Investors rush to jump on the bandwagon and the market over-allocates capital to the "hot" sector(s). The most recent examples being technology, web-based grocery companies, online pet stores and fiber-optic capacity. This herd mentality is the reason why bull markets have funded so many "me-too" ideas throughout history. When this happens, sound fundamental Equity Research is almost ignored.DIFFERENTIATING EQUITY RESEARCHTo discuss the role of equity research in today's market, we need to differentiate between Wall Street equity research and other equity research. Wall Street equity research is provided by the major brokerage firms and investment banks (both on and off Wall Street). Other equity research is produced by independent equity research firms and small boutique brokerage firms, and boutique investment banks.This differentiation is important. First, Wall Street equity research has become focused on big cap, very liquid stocks and ignores the majority (over 60%) of publicly-traded stocks. This myopic focus on a small number of stocks is the result of deregulation and industry consolidation. In order to remain profitable, Wall Street firms including bulge bracket investment banks have focused on big-cap stocks to generate highly lucrative investment banking deals and trading profits. Those companies that are likely to provide the equity research firms with a sizable investment banking deals are the stocks that are determined worth being followed by the market. The stock's long-term investment potential is secondary. The second reason to distinguish Wall Street from other equity research is that most of the blame for the excesses of the last bull market is placed on Wall Street. Other equity research is filling the information gap created by Wall Street. Independent equity research firms and boutique investment bank and brokerage firms are providing equity research on the stocks that have been orphaned by Wall Street. Investors, now educated in the benefits of electronic trading, may not be willing to support boutique brokerage firms for their equity research by opening an account and paying higher commissions. INDEPENDENT EQUITY RESEARCHThis means that independent equity research firms are becoming the main source of information on the majority of stocks, but investors are reluctant to pay for equity research because they don't really know what they are paying for until well after the purchase. Unfortunately not all equity research is worth buying. Many purchased equity research reports from reputable sources can turn out to be inaccurate and misleading.THE VALUE OF EQUITY RESEARCHA good indicator of the value of equity research is the amount institutional investors and hedge funds are willing to pay for it. Institutional investors hire their own analysts to gain a competitive edge over other investors. They also pay (often handsomely) independent equity research firms for additional research. Institutions also pay for the sell-side research they receive (either with dollars or by giving the supplying brokerage firm trades to execute). All this amounts to big money, but the institutions realize that equity research is integral to making successful investment decisions.FEE-BASED EQUITY RESEARCHFee-based equity research increases market efficiency and bridges the gap between investors who want equity research (without paying) and companies who realize that Wall Street is not likely to provide equity research on their stock. Fee-based equity research provides information to the widest possible audience at no charge to the reader because the subject company has funded the equity research.It is important to differentiate between objective fee-based equity research and equity research that is promotional. Objective fee-based equity research is analogous to the role of your physician. You pay a physician not to tell you that you feel good but to give you his or her professional and truthful opinion of your condition. Legitimate fee-based equity research is a professional and objective analysis and opinion of a company's investment potential. Promotional equity research is short on analysis and full of hype. An example is the fax and email reports about the penny stocks that will supposedly triple in a short time. Legitimate fee-based equity research firms have the following characteristics:
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