Studies in Client Profitability

We have reviewed the broker vote and the main factors that contribute to it.  The next logical step is to analyze them and determine if the investment bank is receiving a good return on its allocation in resources.  It's a simple revenues versus expenses calculation.  The art is in determining what the expenses are and how to weight them.  What services are the most important and bring the most value to the buy side?  How much does each service cost?

Within the financial services industry, the most expensive costs are people's time.  For the main roles that interact with the buy side, banks would measure:

Research Analyst - 1x1 meetings, group meetings, field trips, projects/special reports, 1x1 calls, conference calls, entertainment
Research Sales - calls/time spent on client, entertainment
Salestrader - calls/time spent on client, entertainment

For Corporate Access, the statistics would include 1x1 meetings, 2x1/3x1 meetings, group meetings, field trips, presentations, conference calls, special events and entertainment.

In addition to the basic profit/loss analysis, there are scenarios run to estimate revenues if the resource allocation changes.  If a fund is given more meetings, what is the upside in revenue?  What is the downside in revenue if resources are cut?  How should we approach a client who is not giving the firm enough revenues to merit the resources that are given to them?  Here is where senior management needs to make hard decisions.  This is usually the province of a relationship manager for large accounts and sales management for others.  We will discuss the role of the relationship manager at a later time.

A Quantitative Way to Rate the Sell Side - Part 2

In the last article, we summarized the basic points of the McLagan Survey.  There are some frequently asked questions surrounding it that I can answer.

Since each sell side firm sends in their commission data, how can they be sure that it is an apples to apples comparison?
McLagan holds the commission rates for each relationship between sell and buy side firms and the absolute commission dollars are normalized i.e. client a pays $0.01/share to broker 1 and $0.02/share to broker 2.  Broker 1's numbers would be doubled for a like comparison.  International trading commissions are calculated on a basis point rate multiplied by the market capitalization of the trade.  These are gross commissions.  When a sell side firm does not have a presence in a country's exchange, they pay a local broker fee.  These are included in the commission figure.  The same logic applies to soft dollar trades.  To sum up, the buy side firm will designate certain transactions as soft dollar.  The sell side firm will retain part of the commissions and use the remainder for buy side's research expenses i.e. Bloomberg terminals.

How is the survey organized?
The survey is split geographically into 3 regions:  Americas, Europe and Asia.  Americas has the most complete coverage and is dominated by the US with some Canadian firms.  Europe is next with the UK having the largest universe in that area.  Europe is split into UK/Ireland, Western Europe and Emerging Europe.  Asia is the most diverse with the major centers being Japan, Hong Kong and Australia.  Individual country reports are compiled too.

What are the products covered?
Within each region, the products are split geographically and by type.  There are ratings are for Listed (NYSE) and OTC (NASDAQ), Canadian, UK/Ireland, Western Europe, Japan, Non-Japan Asia and Australian securities.  The products are divided into Ordinary/Common Shares traded on the native exchange, American/Global Depository Receipts (ADRs/GDRs), Convertibles, Listed Options and Program Trading.  The smallest data set is the options.

As part of their service, McLagan Partners visits the sell side firms and presents the findings to management.  They will compile special reports that aggregate accounts and calculate the market share.  This can be done for a branch office, a saleperson or salestrader's account package.  As was mentioned in a previous post, this is one of the performance measurement statistics used in evaluating the sales force.  For some packages, this has to be taken with a grain of salt.  In the southwest, there are 3 large accounts and 2 of them have opted out of the survey.

A Qualitative Survey of Sell Side Brokers

Greenwich Associates is a third party research company that advises sell side firms on how they are currently serving their clients and how they can improve.  A review of the www.greenwich.com website lists a wider mission statement that includes both sell and buy side firms.  In this article, we will concentrate on the sell side survey.

The survey starts when Greenwich sends out a list of the buy side firms that will contribute.  The usual suspects are on the list:  Fidelity, Capital Group, Wellington Management, etc.  For these firms, the sell side nominates the contact who will receive the survey.  Also, the sell side is encouraged to add new firms to the list.  This helps Greenwich give the sell side more robust results and add new customers.  The contact for any given buy side firm is by majority vote.  So if 6 firms have John Smith as the contact and 5 firms have Pete Jones, then John Smith will be listed as the official contact.  This is called "ballot stuffing".  Obviously, if John Smith receives the survey, then the 5 firms that speak primarily with Pete Jones will be at a disadvantage.

I have not seen the questionaire but it is qualitative in nature.  These answers are compiled into a rating score on a scale of 1 to 1000.  A total result is given for the entire universe of accounts.  Then ratings are given by each role within equities:  research, research sales and salestrading.  They can be further sliced and diced by account coverage.  For any result to be statistically significant, a minimum of 5 firms have to fill out the survey.  Greenwich also provides account profiles that contain feedback from the buy side firms.  The contents are confidential to sales management.  The salespeople and salestraders covering the account are not to be informed.  However, I always wondered about it.  If the buy side tells sales management of the investment banks on how to improve client service, how would management broach the subject to their staff without giving away the source?  Especially after the Greenwich survey has been published.

Industry Conferences

Buy side money managers and analysts are always seeking insight on the companies currently in their portfolios or on their watch lists. They are looking for any information that would affirm or change their investment thesis. One of the venues where this occurs is an industry conference sponsored by a sell side investment bank. Here, corporate clients such as Intel or Altria will send their officers to speak to the buy side either in a presentation or meeting.

This is where the size or importance of the firm make an impact. In the beginning, the salesperson will invite all their interested clients to the conference. The buy side representative will indicate which corporates they wish to speak to in a group or 1-on-1 basis. This is contingent on the corporates' availability. Some of them will only speak in a presentation setting. Others will desire to have meetings.

Depending on the conference and the sponsoring firm, conferences may or may not be exclusive. So the firm may allow all buy side requests to be approved for attending the conference. Other times, attendance will be tightly controlled. However, for all conferences, meetings and activities (such as golf outings) with corporates are controlled and scheduled by the corporate access team. The meetings and activities are where having a good research salesperson can help a buy side firm. Obviously, for the giants such as Fidelity, S.A.C. Capital or Capital Group; their requests are given precedence. But for a firm on the border, having an advocate that can persuade management to give them a meeting is invaluable and would result in a better broker vote.

Goals of Research Salespeople

Yesterday, we walked through the activities of research salespeople. So how does management measure the work they do? In five ways:

1. The broker vote of their client base
2. Internal vote from research analysts
3. Market share
4. Commissions
5. Cross selling

The first two indicate how well they are marketing the firm's research capabilities. Market share and commissions are the tangible results. Market share studies are run by third party firms and will be handled later. Cross selling is harder to measure. In large institutions, management encourages referrals to other product lines. In practice, this is hard for salespeople to do because they are staking their client relationship on another person who may or may not provide excellent service.

A Day in the Life of a Research Salesperson

Work in the Securities Division starts early. Most salespeople are in the office for the daily 7:30 AM research call. (This is particularly hard for people in California.) These meetings are run by the product management group. An email is sent before the call with the daily overview of ideas. There may be twenty of them. Product management decides which stories are most compelling based on the content, the reputation of the analyst and how it will affect the markets. Then they ask the analysts to promote their ideas in front of the sales force. There is usually only enough time for three analysts. During the call, the sales force will be asking analysts questions about their research.

After the call, the sales force will call their clients. They will use their knowledge of their clients and their importance to the firm to determine the order of their calls. Some items that will influence this decision are:

1. If the client holds the security in their portfolio
2. If the client is interested in buying or selling the security
3. The time a client wants to be called
4. Amount of trading commissions generated by the client

Generally, the salesperson will reach the voice mail of their client. This is the time when preparing a good script or participating in Toastmasters pays off. If you are able to sell an idea quickly, concisely and accurately, then you will be able to call more clients. They will also send emails. For the largest clients, this all happens from 8:15 - 9:00 AM. Then second tier and third tier clients will be called. If the clients are interested in the research idea, they will call back asking for more details or to talk to the analyst.

After this initial frenzy of activity, the sales desk calms down a bit. Salespeople begin setting up follow-up calls for their clients and the analysts, interacting with corporate access to get their client into a conference or non-deal roadshow, talking to Capital Markets about future IPO deals, sending out any research reports, talking to the salestraders to get market information (or color) and addressing any issues their clients may need help with. At times, this will be interrupted by a "Midday Call". In this case, an analyst will have late breaking news and the process for the morning research call is repeated.

Another call is held after the market closes. Sometimes, the day is recapped. An analyst may appear on the call but the urgency is not as strong as the morning call. It's generally more relaxed. Then the sales force returns to serving their clients and may take the clients for a dinner or an event to build strong relationships - which are the essence of business.

Please note that the times relate to the US markets. Other markets such as London, Tokyo and Hong Kong have their own calls but the process is generally the same. This is true for all the native markets. There are salespeople that cover clients in Europe and Asia for the US markets. For a person in London, the morning call would be at 12:30 PM and the evening call would be at 9:30 PM.

Serving the Buy Side

Research, Sales and Trading

The main elements of the broker vote revolve around research and best execution. To better understand this dynamic, look at the traditional roles on the sell and buy sides and their lines of communication. On the sell side, there are four main actors: research analysts, research salespeople, salestraders and position traders. Their counterparts at the buy side are research analysts, portfolio managers (PMs) and salestraders.

Sell side research analysts are the idea generators for an investment bank. They follow a sector or industry and get to know the companies intimately through analyzing financial statements, talking to the company's officers, following industry news and speaking to suppliers, clients and competitors of the firm. They compile all this information into opinions about the prospects for the company's business and stock price. This is known as the "Mosaic Theory". The analysts interface with the buy side's research analysts and PMs; giving them their talking points about different companies. Their recommendation is often boiled down to a buy, hold or sell in the press. The buy side is NOT solely interested in that. They are interested in the thinking process behind an analyst's stock recommendations.

Research salespeople are advocates for their buy side clients. It is their job to obtain the resources needed by them from within the investment bank. This may be a meeting with a sell side analyst or getting them into an industry conference. They market the bank's research capabilities by acting as filters - passing on the most impactful research to a client. For example, if a client has a large position in Microsoft, the salesperson will relay any important research reports regarding that stock to them. A better salesperson may relay news regarding Dell and Hewlett Packard as their sales affect the volume of Windows packages are sold.

Sell side salestraders communicate with the PMs and buy side salestraders. They execute trades and are trying to minimize the transaction prices for the buy side. The calculation of any investment return is dependent on the price of the security when bought. They also act as filters of the investment bank's research. Their ideas are more geared to day trading than any long term investing. Most of the orders are originated by the buy side. At times, they will ask the sell side to facilitate a trade by committing capital. This is something only the largest institutional clients are able to ask for and get.

Position traders interact with the exchanges and salestraders. They have a trading book which has a profit and loss (p/l) statement that is measured constantly. When an order comes from the buy side, the broker/dealer's salestrader will execute the trade through the position trader. Ideally, it will be in the book's current inventory. This is where some friction will appear between the sales and position traders. If the salestrader executes the trade at a good price, the customer will be happy and be more willing to allocate trades to the firm. However, a good price adversely affects the trading book and the p/l statement.

All four roles are large contributors to the broker vote. Whether research or trading is more important is firm specific although each side thinks that they contribute more to the vote than the other. Beyond the client service aspect, there are other items that influence commission allocation such as:

1. Is there is a prime broker relationship?
2. Corporate access
3. Does the investment bank sell the buy side firm's funds?

We will explore these factors later.