In this interactive discussion of equity research, I will review the role of this research and how it is impacted by Bull and Bear markets. I will also discuss fee-based research and its growing importance. Your responses to the questions at the end of this article will be the basis for the last part of this article, where you can observe what investors think is the role of equity research in today's market.

Research and the Stock Market
Actually, the title of this article is a bit misleading because the role of research has not changed since the first trade occurred under the Buttonwood Tree on Manhattan Island. What has changed is the environments (bull and bear markets) that influence research.

The role of 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 under valued). Analysts use their expertise and spend a lot of time analyzing a stock, its industry and peer group to provide earnings and valuation estimates. Research is valuable because it fills information gaps so that each individual investor does not need to analyze every stock. This division of labor makes the market more efficient.

Research in Bull and Bear Markets
If the role of research has always been so "noble", why is it currently in such a state of ill-repute? There are two reasons: firstly, the current bear market gives us a new perspective to evaluate the excesses of the last bull market; secondly, investors need to blame somebody.

In every bull market there are excesses that become apparent only in the bear market that follows. Whether it is tulips or transistors, each age has its mania that distorts the normal functioning of the market. 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 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.

Research is a function of the market and is influenced by these swings. In a bull market investment, the media and investors pressure analysts to focus on the hot sectors. Some analysts morph into promoters as they ride the market. Those analysts that remain rational practitioners are ignored, and their research reports go unread. During the late 1990s the business media catered to the audience's demands and gave the spotlight to the famous talking heads that are now under investigation.

Seeking to blame someone for investment losses is a normal event in bear markets. It happened in the 1930s and the 1970s and is occurring today. Some of the criticisms are deserved, but the need to provide information has not changed.

Research in Today's Market
To discuss the role of research in today's market, we need to differentiate between Dalal Street research and other research. Dalal Street research is provided by the major brokerage firms (both on and off Dalal Street). Other research is produced by independent research firms and small boutique brokerage firms.

This differentiation is important. First, Dalal Street research has become focused on big cap, very liquid stocks and ignores the majority (over 60% based on our research) 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, Dalal Street firms have focused on big-cap stocks to generate highly lucrative investment banking deals and trading profits.

Those companies that are likely to provide the 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 Dalal Street from other research is that most of the blame for the excesses of the last bull market is rightfully placed on Dalal Street.

Other research is filling the information gap created by Dalal Street. Independent research firms and boutique brokerage firms are providing research on the stocks that have been orphaned by Dalal Street. Investors, now educated in the benefits of electronic trading, may not be willing to support boutique brokerage firms for their research by opening an account and paying higher commissions.

This means that independent research firms are becoming the main source of information on the majority of stocks, but investors are reluctant to pay for research because they don't really know what they are paying for until well after the purchase. Unfortunately not all research is worth buying. I have purchased reports from reputable sources only to find them inaccurate and misleading.

Who Pays for Research? Big Investors Do!
The ironic thing is that while research has proven to be valuable, individual investors do not seem to want to pay for it. This may be because, under the traditional system, brokerage houses provided research in order to gain and keep clients. Investors just had to ask their brokers for a report and retained it at no charge. What seems to have gone unrealized is that the commissions pay for that research.

A good indicator of the value of research is the amount institutional investors 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 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 research is integral to making successful investment decisions.

If investors are unwilling to buy research how will the market correct the imbalance caused by the lack of coverage? The solution may be found by looking at the issue a slightly different way.

The Growing Role of Fee-Based Research
Fee-based research increases market efficiency and bridges the gap between investors who want research (without paying) and companies who realize that Dalal Street is not likely to provide research on their stock. Fee-based research provides information to the widest possible audience at no charge to the reader because the subject company has funded the research.

It is important to differentiate between objective fee-based research and research that is promotional. Objective fee-based 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 research is a professional and objective analysis and opinion of a company's investment potential. Promotional 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 research firms have the following characteristics:

1. They provide analytical not promotional services.
2. They are paid a set annual fee in cash; they do not accept any form of equity, which may cause conflicts of interest.
3. They provide full and clear disclosure of the relationship between the company and the research firm so investors can evaluate objectivity.

Companies who engage a legitimate fee-based research firm to analyze their stock are trying to get information to investors and improve market efficiency. Such a company is making the following important statements:

1. That it believes its shares are undervalued because investor are not aware of the company.
2. That it is aware that Dalal Street is no longer an option.
3. That it believes that its investment potential can withstand objective analysis.

Perhaps more importantly, the reputations/credibility of the company and the research firm depends on the efforts they make to inform investors. A company does not want to be tarnished by being associated with disreputable research. Similarly, a research firm will only want to analyze companies that have strong fundamentals and long-term investment potential.

Fee-based research has had to fight the stereotype of promotional research, but the market is starting to realize that fee-based research is a viable source of information. The National Investor Relations Institute (NIRI) was probably the first group to recognize the need for fee-based research. In January 2002 NIRI issued a letter emphasizing the need for small-cap companies to find alternatives to Dalal Street research in order to get their information to investors. More recently, the NIRI is conducting a survey on research alternatives and will possibly have a session on this topic at their national conference this year.

In The Changing Role of Equity Research I reviewed the role of research in bull and bear markets and defined fee-based research. Today's article will discuss the investors' views that came apparent in the responses to the questions at the end of this previous article. Some of the conclusions may surprise many on Dalal Street and corporate boardrooms.

There are a few caveats before we get to the good stuff. First, some may argue that a sample of 1,649 investors is not enough on which to base conclusions. Second, critics could argue that the audience from which the sample was drawn is not representative of the universe of investors.

Both of these are valid criticisms but I think that the audience that we addressed is an important one. Representing the independent thinkers who have not thrown in the towel and moved their savings into mutual funds or mattresses, these investors are the ones who companies want to reach. The group who participated in this questionnaire will be the first to participate in the next bull market.

The information contained in the responses is important because, as far as I could tell, this is the first attempt to ask investors what they think. I have seen many surveys by the National Investors Relations Institute (NIRI) and corporate-oriented publications that survey their membership and industry experts, but I am not aware of any surveys of the people corporations are trying to reach: investors who will use the information in research reports.

It is my hope that this first attempt to determine investors' attitudes toward research will help Dalal Street fix itself. While this survey may have its flaws, it does answer many of the questions I am asked by CEOs and CFOs:"what will the readers think?"

A Surprisingly Strong Response
In the first few days after the first article was posted in the Investopedia newsletter, the response rate (the number of people clicking through the article to answer the survey) was a very high 7.54% of 767 readers. As time progressed, the percentage of responders declined to a total of 4.8% out of a total of 1,649 readers. This is still a very good percentage because the average response rate for any survey is usually less than 3%.

What Do Investors Want? Information.
In isolation, most of the statistics of the responses are as we expected. However, a consideration of the types of responses in relation to one another shows some surprising attitudes. And the percentages left no question as to where the audience stands!

• 84.8% said Dalal Street research is tainted, but 75.9% said it is useful. This was surprising because the media would have us believe that, based upon the divergence between ratings and stock prices, research is worthless.

• 87.3% said that not all fee-based research is biased, and 74.7% said legitimate fee-based research is objective and useful. More importantly, respondents felt that companies that use legitimate fee-based research were making a positive statement about their company's investment potential (a surprisingly strong 70.9%).

Investors prefer in-depth research reports that include industry analysis, peer group comparisons and detailed earnings models (EPS forecasts). Summary reports, target prices and recommendations are not of interest to investors. In short, they want a thorough discussion of current business situations and the benefit of experienced analysts' evaluations of the investment potential and forecasts of the earnings of a company. Hold the target prices and don't "biggie size" any recommendations.

The Bottom Line
Investors are more aware than corporations and the media think they are. The survivors of the biggest crash since 1929 know the difference between "good" and "bad" research but realize that they need information in the form of research reports. The research can come from Dalal Street or independent fee-based research firms, but it had better contain an objective analysis of current conditions, comparative data and a detailed earnings model so that investors can make up their own mind.