How the London Stock Exchange Works
The listed corporation deals with three main parties in the equity markets: sell-side analysts, investors, and financial journalists, as shown in Figure 4.1.
Figure 4.1 The company-equity market interface
Analysts can be divided into three types:
Sell-side analysts have been an important feature of the U.S. equity markets since the 1920s, although they were not common in the United Kingdom’s markets till the 1960s (Golding, 2003). They usually work for investment banks. Their job is to publish research on companies in order to encourage the trading of its stock. They are remunerated according to the commissions they generate from their clients trading of stock. They are therefore attracted to large-cap stocks, with large daily trading volumes. Analysts each invest considerable time analyzing a small number of companies to provide earnings and valuation estimates. Analysts are the “financial detectives” of the financial markets (Kleinfield, 1985), with the average analyst covering 16 stocks (Groysberg, Healy, and Maber, 2011). Analysts are usually financially qualified and also pick up qualitative skills of assessing industry prospects, firm strategy, and management competence. Analysts, despite their problems (most notably their overfocus on large-cap stocks, a high degree of herd-instinct, and far from insignificant conflicts of interest), provide market efficiencies by circulating analysis on companies so that investors do not need to analyze every stock. The role of analysts is to produce forecasts of stock prices. In a stock market where all investors used the same measures of value, this might be achievable, but since so many different methodologies are in use, a stock price is nothing more than a market average of varying valuations, and so most stock prices are highly vulnerable to change. Predicting stock prices is therefore about as scientific as astrology, and valuing stock is something that investor relations (IR) departments should not assist with. Management should not even have a view on the company’s stock price, but the prevalence of stock price triggered payments to managements (usually in the form of stock options) has blurred the line between the role of the markets (valuation) and the role of management (performance). It is the view of this author that the single most important cause of “earnings management” is the existence of stock price–related bonus schemes for executives. The truth of the stock markets is that valuations are nothing better than educated and collective (and often self-serving) guess work. Even the historical performance figures that are used, despite being the most objective part of corporate performance analysis, are somewhat subjective, as anybody trained in the compiling of financial statements knows:
The accounts of a corporation carrying on a complex modern business are not, and cannot be, statements of absolute fact. They are necessarily based largely on conventions, on estimates, and on opinions ... I have found from experience that it is by no means always fully appreciated even by people who might be supposed to be well versed in financial affairs. (May, 1932)
Small-cap stocks tend to be neglected by analysts, creating a vicious circle of poor publicity, which is somewhat alleviated by the role of fee-based research. Sell-side analysts represent the best-researched actors in the financial markets. They are the public face of IR because of the glamour of their work, their high profiles in the business press, and the semipublic nature of their research.
Senior analysts make between £150k and £400k, with a bonus of similar size based on commission and fund manager ratings. In November 2007, the Financial Services Authority unbundled commissions in their implementation of the EU’s “Markets in Financial Instruments Directive I.” Only execution costs and research could now be included in commission. The future of sell-side research is again in question since from Jan 2017 investment banks will be prohibited from paying for sell-side research out of commissions, one of the many changes included in “Markets in Financial Instruments Directive II.”
Buy-side analysts are much more recent than sell-side analysts. The “widespread dissatisfaction with the quality of sell-side research” (Citigate Dewe Rogerson, 2014) by both companies and investors resulted in companies prioritising direct contact with investors, and investors conducting more of their own research, which is called “buy-side” research. Buy-side analysts were established in the 1990s by institutional investors because of the perceived bias in sell-side research. They tend to cover a larger number of stocks and produce less-detailed research, which is only for the use of the portfolio managers within the institutional investor in order to make investment decisions. Although the buy-side is less glamorous than the sell-side, since buy-side analysts do not have a public profile, their research is more objective and credible from the perspective of portfolio managers.
Fee-based research. Paid for research is utilized by small firms that do not have many sell-side analysts covering them. It varies in credibility and detail, but can be an important part of the marketing of small stocks. Investors. The term investor is somewhat of a personification since investment decisions typically involve multiple people, but the key decision makers in investment management firms are usually entitled “portfolio managers” and manage a particular portfolio of investments within an investment management institution implementing its investment strategy and managing the day-to-day portfolio trading of securities on behalf of clients, in accordance with the investment objectives and parameters defined by those clients. Fees charged by investment managers to their clients are generally based on a percentage of client assets under management. Media. Some investor relations officers (IROs) have responsibility for financial public relations, others don’t. The financial press (the business pages of the quality press, investment magazines, and relevant trade press titles) can be very influential for reputation, especially for consumer businesses. Financial journalists tend to be very focused on headlines, much keener on bad news then good news, and not highly knowledgeable about business. Some CEOs would rather keep out of the press entirely, while some are very media friendly. IROs should follow their corporate traditions on this, and liaise closely with the director of communications.
Figure 4.2 Stakeholder expectations (© BRE BANK SA 2009)
A core principle of effective communication is to understand the needs of different audiences. Figure 4.2 shows the typical information requirements of different stakeholders; the bottom three are different types of investors, with analysts above them and rating agencies at the top.
Although all market participants have the right to equality of information, by knowing what different market participants are looking for, companies can assist their decision-making and obtain a more favorable response simply by ensuring that all investors have the information they need.