Michael Waterman, a Market Research Analyst at Nicholas-Applegate, conducts research and is responsible for providing analytics to the entire firm. Mr. Waterman works closely with the investment teams to develop presentations which are used by the firm's investments and sales teams for marketing to potential and existing clients. He earned his B.S. in management science from the University of California San Diego. Mr. Waterman is a member of the CFA Institute and the Financial Analysts Society of San Diego and has six years of investment industry experience.

Regulation Fair Disclosure (Reg. FD) is responsible for a shakeup in the investment industry research process. Public pressure, corporate malfeasance and lack of investor confidence in the integrity of the capital markets forced the Securities and Exchange Commission (SEC) to re-evaluate required methods of corporate disclosure. Reg. FD, enacted in October, 2000, addresses selective disclosure providing that "When an issuer, or person acting on its behalf, discloses material non-public information to certain enumerated persons (in general, securities market professionals and holders of the issuer's securities who may well trade on the basis of the information), it must make public disclosure of the information." (SEC, Reg. FD executive summary).

Before October 23, 2000, many successful analysts focused their research efforts on relationship cultivation with company managements rather than financial analysis and due diligence. Reg. FD curtailed relationship based analysis and promoted a different avenue in which to conduct company research, wherein the ability to effectively process information superseded access to information.

We conducted a study to try to understand the impact of Reg. FD on share price movements. (See Exhibit 1.) We looked at share price behavior before and during a positive or negative surprise announcement. Before Reg. FD, fully 80% of the excess return (positive or negative) happened prior to the announcement date, as shown by the top and bottom lines in the Exhibit. Information was leaking out into the market and participants were acting on it. Post Reg. FD, none of the excess return occurred prior to the announcement and most of it occurred between the announcement and the next day’s opening. Reg. FD has leveled the
playing field for all investors.

Perhaps one reason why the SEC waited so long to implement Reg. FD is because prior to the late 1990s, public access to information was substantially more limited than it is now. Historically, investors relied heavily on analysts to inform them of company activity and financial information. However, with the explosion of the Internet and advances in communication, the general public now has the ability to research company information without an intermediary. Additionally, corporations now have the ability to communicate to shareholders directly and in real time. As such, Reg. FD mandates that firms communicate material information to all investors concurrently via accepted channels, such as public press releases, SEC filings and public conference calls. Companies are being extremely careful not to otherwise release any information that could be considered material. Horacio A. Valeiras, Nicholas-Applegate's Chief Investment Officer, related, "Before a recent large IPO, management of the company visited Nicholas-Applegate.

During the meeting, it became obvious that management had a script they were following and they would not deviate from it. We asked them many questions to which they responded with, 'We’re not allowed to answer that.'" This company avoided answering some of the questions because it is required to share meaningful information with everyone simultaneously--not just industry insiders. Mr. Valeiras continued, "Before [Reg. FD], companies would guide you and give you a feeling of where the company was going, and if you were one of the first analysts to interview the company, you had the inside scoop. Now, everyone has access to the same information at the same time, which creates a better environment for all investors."

More and more, analysts are finding that they have to work harder now at researching companies and  piecing together material information than they did prior to Reg. FD. Montie Weisenberger, Healthcare Analyst at Nicholas-Applegate, shared, "Five years ago, an analyst could make a quick call to the CEO of a healthcare company and ask him or her whether the company would meet its numbers, and he or she  could tell the analyst if their estimate was in the range. Now, analysts have to spend considerably more time with company executives and have them walk us through their lines of business. In addition, we now have to talk to suppliers, end users of the products and industry consultants to arrive at the same point."

Successful analysts now piece together mosaics of information rather than receive material information directly from companies. The mosaic process involves collecting material public information and non- material non-public information to gain an understanding of the value of a company. This extra work entails frequent and lengthy calls to company management. In the pre-Reg. FD days, an analyst typically had a handful of standard questions ready for the call. Today, analysts must be well prepared for company calls. Mr. Weisenberger stated, "Another thing you have to do now is to really do your homework and prepare a lot more for management calls. Before [Reg. FD], you could go into a call as a buy-side player and management was ready to give you what you needed. Now, you have to prepare on the front end so you can ask the right questions in the right way to get them to talk about things." Knowing what questions to ask is critical to successful research and sometimes requires analysts to be experts in their sectors. This helps the analyst to efficiently apply the mosaic process and allows him or her to deduce information that is critical to the investment decisionmaking process.

Analysts lob more calls to management than before and rather than ending the research process there, they call on additional resources, including other management personnel, sell-side analysts, suppliers, customers and independent research firms to obtain meaningful company research. Whereas the earnings projections of the sell-side analyst once played the most significant role in conducting research for many buy-side analysts; now sell-side analysts are used for surveys, detailed financial and market models, earnings  estimates, and as a clearinghouse for industry information. Because the public generally receives the same company information that sell-side analysts do, investors continue to put less weight on analyst recommendations. (See Exhibit 2.) Also, large brokerage houses are reducing their budgets for research staff, resulting in reduced universe coverage. Mr. Weisenberger views this as an opportunity: "This [less analyst coverage] can give you an edge if you know how the universe [of stocks] is moving and you have a sound investment philosophy that you apply consistently." Successful analysts have learned to adapt to the changes introduced by Reg. FD.

Prior to Reg. FD, compaines receiving the most favorable earnings revisions (Quintile 1) outperformed issuers with the least favorable earnings revisions (Quintile 5) 67% of the time for large-cap issuers and 80% for small-cap issuers. In the post-Reg. FD environment, investors are not weighting analyst recommendations/revisoins as heavily as they did pre-Reg. FD, as 51% of large-cap companies and 61% of small-cap issuers with the most favorable revisions outperformed those with the least favorable revisions.

At the same time, successful investment firms have also learned to adapt to Reg. FD. Such firms have deepened their research teams so that each analyst can develop greater expertise in his or her assigned sector. They have implemented a structure for their analysts to follow and an evaluation system for their analysts. Successful firms have determined which third-party firms provide the best research. Additionally, they continue to upgrade their technology platforms in order to quickly access and assess information. They also place more value on a robust compliance system that is capable of precluding violation breaches. Finally, the firms that will prevail in the post-Reg. FD environment will continue to search for new ways to refine and improve their research processes.

Outlook for investment industry research appears stable as regulators have recognized its importance. We do not foresee further significant regulation of investment research in the near term, including soft dollars. We will probably see the continued tightening of research budgets by large brokerage houses, leading to reduced company coverage. We are also likely to witness an unbundling of research versus trading executions. This means buy-side analysts will have to take on the role sell-side analysts performed prior to Reg. FD, including migrating toward sector-specific coverage, following data and trends, keeping abreast of ways to manage and interpret large amounts of information, increasing direct communication with management, participating in teleconferences and attending conferences. Analysts will continue to develop ways to take advantage of the mosaic process. According to Mr. Weisenberger, "The firms that have the right skill-sets in place, well defined investment philosophies and processes, and the talent to execute them are exceptionally well positioned to succeed in the post-Reg. FD environment."

Reg. FD has provided many benefits to the investment research community in addition to the individual investor, including the increased integrity of research. The diligent analysts who have always had the strong work ethic and inquisitive nature have remained, while those lacking these characteristics have departed. Investment firms have continued to espouse the post-Reg. FD-type analyst. The result is higher quality investment research and a much stronger foundation for the investment decision-making process.