Investor: An insiders guide to the marketInvestment research written and distributed by stockbrokers is an activity that has come under the spotlight in recent months. The key issue that has arisen relates to the conflicts of interest that are inherent in the investment analysis process.
Globally, most stockbroking firms are owned by investment banks such as Merrill Lynch, Goldman Sachs and Credit Suisse First Boston to name only three. This corporate structure is mirrored in the Irish market where the three largest stockbroking firms are owned by banks. Davy is a subsidiary of Bank of Ireland, Goodbody is owned by AIB and NCB is effectively owned by Royal Bank of Scotland. For these integrated financial services companies, investment research performs a dual role. Firstly, it is distributed to institutional and private investors to encourage them to buy or sell shares.
The second usage of research is as a tool to gain lucrative corporate finance business. Initial public offerings (IPOs), privatisations and mergers and acquisitions are activities that generate substantial fees and, not surprisingly, investment banks devote enormous resources to secure such work. High-quality investment research is a prerequisite to secure such business, not least because it serves to convince corporate clients that an investment bank has a stockbroking arm capable of successfully selling a company's shares to investors.
In the US recent high-profile investigations have exposed the downside of this structure and it is clear that in many instances investors were duped into buying over-priced shares by many investment banks.
In the UK and Ireland it does seem as if the excesses in the US markets did not occur. Nevertheless, it has long been the case that most share recommendations issued by stockbrokers are "buy" rather than "sell". In part, this reflects brokers' innate bias towards optimism, but it also reflects a desire not to upset the senior management of quoted companies as this may damage the brokers' corporate relationships.
In this context, the recent spat between Merrion and Irish Life & Permanent (IL&P) provides an interesting case study in how the market works. In an investment report dated May 19th, Merrion recommended its clients to "reduce" their holdings in IL&P. While the recommendation was not to sell, in the arcane world of investments the "reduce" recommendation was tantamount to a "sell" recommendation. On May 28th, the broker issued a four-page note with some corrections and clarifications to the original document followed by a revised full report. These revisions related to technical issues surrounding IL&P's capital position where there were some factual errors.
The report provides a detailed and thorough analysis of IL&P and, in particular, focuses on the company's capital structure and how dividend payments are financed. IL&P is unusual in that it is a genuine hybrid of a life assurance and banking business. In contrast, AIB and Bank of Ireland are banks that have developed life assurance subsidiaries. The accounting conventions and regulatory requirements associated with a life assurance business are notoriously complex. The Merrion report tackles these issues head on and, from an investor perspective, the report is a valuable contribution to understanding the company.
The Merrion report attempts to establish a "fair value" for Irish Life shares based on a "sum-of-the-parts" approach. This involves estimating a capital value for the different business segments and adding these values together.
The Merrion analysis places a value per share for IL&P of 996 cents to 1,030 cents. This compares with the share price at end-May of €10.50. A weakness in this "fair value" approach is that even a small change in the underlying assumptions will usually have a big impact on the end result. In recognition of this, the Merrion report provides tables showing a comprehensive valuation range varying the critical assumptions. This fuller valuation range results in a value per share of 893 cents to 1,285 cents. On the basis of this valuation approach and its assessment of future trends, Merrion's analysts conclude with their "reduce" recommendation.
Irrespective of the technical errors identified by IL&P (subsequently corrected), investors should applaud Merrion for an original and informative research report and one that is clearly independent of any conflicts of interest.
