As an investor, which do you think is worse: (NYSE:A) equity research whose objectivity may be compromised by favorable comments in deference to a firm's investment banking clients; or (NYSE:B) no research at all?
If you picked the former, then welcome to Wall Street circa 2002, before then New York Attorney General Eliot Spitzer's Global Research Settlement.
If you picked the latter, then welcome to Wall Street today.
In the dot-com era, when we were all sure it really was going to be different this time, equity research was freely flowing. It was left up to the reader of the research to decide if clicks and eyeballs were better than profits and cash flow as the primary metrics for making investment decisions. The most important thing is that there were choices. You could read the research and then choose whether or not to believe it. Or you could ignore it altogether.
We no longer have those options. The absence of equity research is among the elements that contributed to the Facebook IPO fiasco. Under current securities laws, members of an IPO underwriting syndicate are prohibited from publishing equity research before and up to the IPO pricing date and for a period of 40 days after the pricing of an IPO. Just to be clear, the analysts can and do speak to management of the issuer. And these same analysts can and do speak with their firms' preferred customers-i.e., large institutional investors-so-called "whispers." They just don't speak to the unwashed masses, otherwise known as retail investors. In the case of Facebook, the insiders were tipped off-entirely legally under the current rules-of softness in one part of the company's business. Retail investors never got the memo or the whispers.
So who cares? Hasn't Wall Street always screwed the little guy? Isn't that just the natural order of things?
Cynicism aside, anyone who cares about innovation and job creation should care very deeply about capital formation and the integrity of the equity markets. Why? Because they are all inter-related, and innovation and job creation are only possible with capital formation, which in turn is a function of fair and efficient capital markets.
There's a saying on Wall Street that "readers don't buy; and buyers don't read." The reading in question is of the prospectus for a new issue. There are so many risk factors listed in a prospectus that an average reader not accustomed to such documents would run for the hills and hide his wallet.
That's where equity research fits in. Analysts are professionals who play a vital role in filtering through the legalese of an issuer's SEC disclosure documents to assess the real risk and return potential for each security. Their job is to put an estimated dollar value on a stock. It is up to the reader to determine whether any gap that may exist between an issue's stock price and an analyst's price target represents a good bet.
The JOBS (Jumpstart Our Business Startups) Act, which was signed into law on April 5th, takes two important first steps on the research front. First, the Act specifically allows investment bankers and research analysts to formally collaborate on an IPO (although appropriately retaining the independence safeguards designed to protect investors). And second, the Act allows equity research to be published immediately after an IPO, instead of waiting 40 days. These changes are badly needed to reinvigorate the capital markets, but they don't go far enough.
Both these reforms only apply to the newly designated category of emerging growth companies (EGCs) -those with less than $1 billion of revenue and under $700 million of public float. In other words, definitely not Facebook.
Furthermore, although the Act specifically allows pre-IPO analyst research reports for EGCs, existing restrictions continue to prohibit pre-IPO publication or dissemination of research reports for EGCs until further SEC and FINRA interpretative guidance is issued. So instead of allowing pre-IPO research reports available to the masses for both EGCs and non-EGCs alike, the same Facebook "whispers" to large institutional investors before the IPO continue to be condoned.
Consider the irony of this situation. Facebook (NASDAQ:FB) is a company with 900 million users and represented the largest venture-backed IPO of all time. The sheer size of the $16 billion IPO coupled with the unusually high 25% allocation of shares to retail investors, made the transaction screaming with systemic risk. But no research was available to the unwashed masses, a number of whom were purchasing stock for the first time, because the company was too large. Go figure.
U.S. Supreme Court Justice Louis Brandeis famously wrote that "sunlight is the best disinfectant," referring to the benefits of openness and transparency in the securities markets.
As a starting point, all road show presentations and related materials used in connection with the marketing of an IPO should be filed with the SEC and be available to all investors. These materials are far more understandable to investors than the regulation-centric prospectus.
Ideally, the welcome reforms in the area of equity research that EGCs now enjoy under the JOBS Act would be extended to all companies, if for no other reason than to help prevent another Facebook-type IPO fiasco from occurring. And the SEC and FINRA should be directed by Congress to allow the publication of pre-IPO research reports for all issuers and for dissemination to all investors.
The markets have mechanisms for making rational adjustments to equity research that is compromised, too optimistic or both. Of course, those mechanisms can't function when there is no research in the first instance.
Now to answer our own question about which is worse: potentially compromised research or no research at all-we choose . Pick your poison.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: The opinions expressed in this article are the opinion of Timothy J. Keating only and are not intended to be a solicitation to purchase or sell any security. Neither Timothy J. Keating nor Keating Capital own shares of Facebook and have no plans to purchase shares of Facebook.