Many in the industry have long bristled when hearing that sell-side (brokerage-sponsored) equity research is somehow better than company-sponsored research because corporations haven’t traditionally paid for it. This is a misnomer. Not to be entirely cynical: it has served important functions such as providing grist for broker discussions with clients and in-depth analyses of covered companies’ prospects, competitive position and investment appeals.

But the bottom line is that the fees related to capital raising and financing have historically covered the cost of doing analysis and maintaining research departments. Research was a perk to covered companies, and a sales tool for retail and institutional stock brokers.  To anyone who argues that brokerage research was more credible than quality company-sponsored research need only look at the late 1990s when “all star” analysts were endorsing the outrageous financial models of Internet and technology companies destined to fail, and further bolstering these companies with enthusiastic “buy” recommendations and fantastic price targets.  In 2000, First Call found fewer than 1% of analyst ratings were “sell.”

The 2003 Global Settlement of Conflicts of Interest between Research and Investment Banking was designed to create a “Chinese Wall” between equity research and investment banking business.  Although this may have given sell-side analysts more freedom and helped restore credibility, it has, not surprisingly, mortally wounded sell-side equity research.  Since investment bankers can no longer guarantee positive coverage or even coverage at all to their clients, equity research is a cost center, ripe for downsizing.  First on the block: coverage of companies least likely to generate significant investment banking dollars.

John M. Dutton, president of Dutton Associates, notes: “With the number of brokerage analysts cut by over 50% since 2001, sell-side coverage firms gravitated to where they can make money and to stocks that already have liquidity, ignoring the micro- and many small-cap companies.  Many of us have had long careers in senior management positions in the brokerage industry with major firms.  We all believe in the value of good research, widely distributed, as necessary to the functioning of the equity markets.”

A 2008 article in the Financial Analysts Journal, Buy-Side vs. Sell-Side Analysts’ Earnings Forecasts, co-authored by three Harvard Business School professors noted: “By limiting the investment banking benefits from sell-side research, an (unintended) consequence of the Global Settlement has been to reduce sell-side research budgets at leading investment banks and to encourage the growth of buy-side research.”

Sell-side firms continue to reduce their coverage of industries, trimming the number of covered companies and limiting coverage to only the largest of the large capitalization firms. Another trend discouraging research is the number of brokerage firms placing significant limitations on what their investment advisors can recommend to clients (market cap and minimum stock price restrictions, daily trading volume, focus on managed accounts versus individual stock picking).  This reduced need for research goes hand-in-hand with the economic decision to continue reducing research.

Bottom line: this trend has severely limited opportunities for smaller corporations to receive coverage or to have an independently constructed business/financial model available to investors. Less information is bad for investors and bad for companies.

As the article in Financial Analysts Journal noted, some research has gravitated to buy side investors – institutional investors and money managers.  For a number of years the buy side has shown decreasing interest and confidence in sell-side equity research, instead producing internal research that reflects and supports their particular investment strategies.  In many buy side firms, individuals play the dual role of support-providing analyst and profit-generating portfolio manager.  The research is entirely proprietary – never shared outside the firm.

Some excellent capital-raising firms specializing in small cap companies still produce research. However, as with buy side firms, distribution of this research is limited: clients, broker networks and possibly other affiliates. The same holds true for the handful of companies that create models and analytics to sell to money managers and institutional investors – only subscribers receive it, and the subscription price is not cost-effective for individual investors or smaller money managers and investment advisory firms.

None of this buy-side research or information is distributed to widely used investor services like Bloomberg, Zacks, etc. for their users to access.  Nor is it posted on the web.  Nor are full reports and updates accessible for downloading from a website.

Today’s equity investment research scene is highly fragmented and exceptionally limited.  A decade ago it was realistic for a solid-performing small cap company to reasonably expect full or at least partial coverage from four, possibly five analysts.  Today, most small- and micro-cap companies are lucky to have one.

Dutton Associates gives any and every corporation access to independent modeling and analytics, broad distribution to investor websites, and easy availability of all reports and updates.  True, the covered companies pay for this research.  However, Dutton’s reputation and the continuing value of its research and models depend entirely on its quality and accuracy.  Dutton’s analysts adhere to the highest industry standards set for research and analytics of any kind, playing by the same rules as every other top-rated analyst.

We like the fact that Dutton is not afraid to turn down a prospective client if its initial review indicates significant flaws in the company’s business model or operations. According to the firm, Dutton turns down about 30% of the companies that approach it for coverage.  Its experienced analysts have to be credible to provide value to investors, who also are the ones making the final decision about whether or not they agree with the research and model being offered – no different than it has ever been with equity research.

Dutton explains: “The issuer paid industry in 2004 was addressed by the Chartered Financial Analysts Institute and the National Investor Relations Institute in their Standards piece published in December of that year.  What we and the CFAI have done with the standards was create a platform that could address this very significant market segment – small and micro cap – and have an economic underpinning that allowed good firms and analysts to generate revenues to pay their costs.

“We worked with the CFAI to make the proposed standards equivalent to NASD Rule 2711 governing research post the 2002 settlement.  You will find this to be the case where a few of us closely follow these standards. Additionally, my belief was that to be effective, the quality of analysts had to equal those on the brokerage platform.  As you can see from our analysts’ bios, all most all of our analysts were senior analysts at the major brokerage firms, many former Directors of Research, All American, etc., prior to joining Dutton.”

Dutton’s company research is broadly available at www.duttonassociates.com, where investors can download reports and research updates on any of Dutton’s clients.  Ratings and updates are sent to thousands of Internet investor and news sites.  This is impossible with any other research generated by the sell side or buy side.  Capital Insight Partners believes this caliber of paid-for research provides a great service to investors and companies, particularly in these times when any kind of substantive and widely-available research is in scarce supply.

Dutton’s internal analysis shows returns of its covered companies averages +9.3% after 60 days of coverage, outperforming the Russell 2000 by nearly 4 times, and 30% after 1 year, outperforming the Russell by 2 times.  Volume increased 380% after 1 year on average, excluding maximum and minimum values. Investors pay attention, and for a good reason.