How MiFID II could hurt Small and Mid-caps

Afternoon all,

Hope everyone had a restful weekend. The truly dreary weather allowed me to spend time going through some of my core holdings, checking my investment theses still stand, without raising the ire of my better half too much. Having gone through them, I've decided to do a bit of an overview next week on roll-outs: how I think about them; which ones look interesting; what caused unsuccessful ones to blow up; etc.

This week I'm pushed for time as I am travelling, so I will write a brief piece about the seismic changes that are coming to the investment industry, and why it concerns me, as a fund manager focussed on the small-caps.

MiFID II will reshape the landscape for research

In case you've never heard of MiFID II, put briefly, it is a huge piece of EU legislation coming into force at the start of 2018 that covers all financial instruments (i.e., shares, bonds, ETFs, funds, derivatives, etc.). Among other things, it will change the way fund managers pay for research which could have profound implications for capital markets at the smaller end of the spectrum. 

If you're UK-focussed and you think that, since we're leaving the EU then it won't affect us, then think again. The legislation has been spearheaded by the FCA and will be fully adopted whether we are in or out of the European Union.

Why change was necessary for Research payments

The primary factor that will impact my life is the changes to how we must pay for research. The established model has been for Banks and Brokers to spread their research far and wide and look to get paid after the fact, in the form of commission charges on trades or through direct payments. Historically, these costs were usually passed on to the investor in the fund.

The conflicts are obvious and clear. The fund manager has little incentive to keep costs down as they are passed on, and the picture built up is that of a gravy train, with lots of unnecessary research and the costs carried by the end-investor.

The second charge is that the big, established Banks and Brokers use research as a bit of a loss-leader in the search for corporate clients, retainers and the big pay day when the next IPO or Rights Issuance comes along. This makes it difficult for Independent Research Houses to compete. They are usually small and have to levy a high price for their research to make a profit.

The new system will mean fund managers specify how much they are paying for research and then either pass it on to investors or pay for it themselves.

But...Why I believe it will damage capital markets for SMEs

For the large-cap equities, currencies, commodities and indices, the changes should reduce research to a more manageable level.

However at the small to mid-cap end of the market, clearly the most exciting area, the good intentions of the regulators will, I fear, make things worse.

The argument for the independent research providers doesn't hold much currency for smid-caps in my view. Analysts need a monetary incentive to write research, just as my builder won't do our drive out of the kindness of his heart. Markets at the smaller end of the spectrum just don't have the liquidity to attract enough independents to come in, cover the companies, and earn a reasonable living.

Also, there are so many companies to keep tabs on, and so much change, you need Brokers, and increasingly commissioned research houses, to help introduce you to new businesses and provide the sensible analysis and forecasts to use as your starting point for your own research.

Luckily for me, I have a team of analysts who do a lot of the heavy lifting for me, but many funds do not have the teams internally to do this. Do we really want to create a system where only the big fund managers can properly operate at this end of the market?

We've had results from mid-cap Broker recently that demonstrate what a tough period it is for them. If the commissions these firms receive dry up even further, which is surely the case, then that can only mean a reduction in research coverage.

I would be tempted to say "great, more mispriced assets for me to invest in". However, less research coverage in a market already lacking in coverage means:

• Less daily liquidity, more volatility and more pricing anomalies,
• An increasingly unattractive market for SMEs looking to raise capital,
• Retail investors getting burnt by more pricing bubbles,
• And ultimately, fewer quality companies joining the markets in which I can invest
  

Listed Corporates will end up bearing the cost

The only solution I can see, once the changes are enacted, and the market adapts accordingly, is that Brokers will have to start increasing the amount they charge their corporates for research.

The other outcome will almost certainly be a further consolidation of Brokers. I would much prefer to see this, rather than a race to the bottom as Brokers chase corporate clients with lower, and lower annual fees. In both cases, we may, unfortunately, see a thinning out of research.

As well as offering research to HNW private investors, platforms like Research Tree are also working to monetize Broker Research in new markets (e.g., Wealth Managers, PCBs, IFAs, PR, etc.). Historically many of these companies received a lot of research for free, but this will have to change. I applaud the ambition, which is why I decided to write on their site, and in time it could provide a decent incremental revenue source for brokers as well as an excellent service to private investors.

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To read a brief outline of how I think about stocks, and what I aim to achieve in this blog, please check out my first blog where I set out my stall.

Recent blogs:

• 23 Jan 17 - Why Pearson was an obvious value trap, and is Jackpotjoy worth a closer look?
• 16 Jan 17 - How sustainable are current dividends
• 8 Jan 17 - Implications of Trumponomics for equities
• 18 Dec 16 - Millennials - Becoming the most important demographic
• 12 Dec 16 - CFDs - Tough week but worth a closer look
• 5 Dec 16 - Pension deficit dogs starting to look interesting
• 28 Nov 16 - Setting out my stall...plus my thoughts on bond proxies 

Please Note: To be clear, I do not and will not ever give any advice. I will rarely mention individual stocks but when I do these will not be recommendations, instead just my thoughts at that point in time.