Best Practices for Equity Research Analysts: Essentials for BuySide and Sell-Side Analysts

by James J. Valentine McGraw-Hill. (c) 2011. Copying Prohibited.

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BestPracticesforEquityResearchAnalysts:EssentialsforBuySideandSellSideAnalysts

Introduction
No man was ever wise by chance. - Attributed to Seneca the Younger Need for Best Practices There are plenty of obstacles to learning best practices. As Ive spent time studying the training profession since leaving Wall Street, its become clear that theres one major difference between the learning we do in our profession and the learning we did in college: The whatsin-it-for-me factor is much higher for professionals. Without a clear incentive system, most professionals dont see the point in continuing education. Further raising the bar for professional learning, many corporate training programs are not learner-centered, but instead built around the needs of management. This is similar to how the computer industry failed to deliver user-centered solutions until Apple came along. I cant say the material in this book will be as exciting as a new iPhone or iPad app, but it has been assembled with the learner in mind, enabling quick access to the knowledge and skills required for success. Some analysts may ask, Why do I need to learn how to be an analyst when I can just learn it on the job?Their competitors are glad these analysts have this view, because it increases their odds of failure. This was echoed by the director of research of a large hedge fund who said, We like that there are a bunch of people doing mediocre research, because it gives us more opportunities.Heres why there is a significant need for best practices within the profession:
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Most on-the-job training for equity analysts follows the masterapprentice model, which has some notable flaws. Most new equity analysts work for senior producers who have little time to train new hires. After all, portfolio managers and senior sell-side analysts get paid to identify mispriced stocks, and when they fail in their primary role, it can lower their compensation (by six or even seven digits). This often distracts from their secondary role as trainer. Their intense focus on getting stock picks right often leads to a sink-or-swim environment for the new hires under their wings. Those producers who rightly make the time to train new hires may not have a style of conducting research worth emulating or the patience required to train others. The ugly truth is that the majority of money managers underperform their benchmark, which means theres a good chance the mentor is passing along poor practices (or lacks the best practices).

Here are some of the more pronounced situations where equity analysts go wrong, which could be avoided by adopting best practices:
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Cover too many stocks or fail to effectively manage inbound information flow, which reduces the likelihood of identifying unique insights required to generate alpha. Fail to understand the critical factors likely to drive a stock, which leads to spending too much time on factors that wont move a stock and too little time on those that will. Dont develop the unique industry contacts and information sources required to make differentiated stock calls. Dont understand how to interview a management team or industry contacts in a manner that extracts unique insights. Fail to understand how companies and the media can deceive through numbers, thus missing opportunities to avoid the blowups. Generate financial forecasts with no basis other than an inexperienced gut feeling or company management guidance, leading to earnings and cash flow forecasts well above realistic levels. Apply premiums or discounts to valuation multiples on an arbitrary basis. Communicate stock messages ineffectively, either by being too verbose or failing to identify how the analysts work differs from consensus. Make poor ethical decisions due to a lack of understanding of how to spot and defuse conflicts of interest.

The Road Map The best practices that follow are intended to help analysts avoid these mistakes as well as overcome typical challenges more easily. Theyve been divided into the five primary areas of the equity research analysts role, as highlighted in Exhibit
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BestPracticesforEquityResearchAnalysts:EssentialsforBuySideandSellSideAnalysts

1.1. Exhibit 1.1: Primary Tasks of an Equity Research Analyst

Copyright McGraw-Hill and AnalystSolutions

1. Identify and monitor critical factors 2. Create and update financial forecasts 3. Use valuation methods to derive price targets or a range of targets 4. Make stock recommendations 5. Communicate stock ideas Before an analyst can jump into any of the five areas, its important to develop organizational and interpersonal skills, such as time management, setting up an information hub, and influencing others. These topics are covered in Part 1. Once this foundation is established, we discuss the best practices for generating qualitative insights in Part 2. These best practices help analysts identify the critical factors and information sources necessary for better forecasting. Part 3 explores the best practices for generating quantitative insights, such as utilizing statistics, accounting, and Microsoft Excel to create a better set of financial forecast scenarios than consensus. Then, we move on to Part 4 to cover the best practices for valuation and the all-important stock picking. And the job doesnt end there; analysts need to effectively communicate their message if they are to be rewarded for their efforts. We explore this topic in Part 5. We conclude by highlighting best practices for making critically important ethical decisions in Part 6. Just a Few Truisms In general, I believe each problem should be solved with its own unique tool, and as such, Im hesitant to offer sweeping advice about how to be a successful analyst. But as I was assembling the book, it occurred to me there were a number of themes that transcended more than one best practice. Here are some beliefs I subscribe to that were reinforced from the research conducted for this book:
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Be skeptical, very skeptical, and even more skeptical. Great analysts rarely accept anything at face value. Douglas Cohen, who has spent 16 years at Morgan Stanley as both a sell-side analyst and a portfolio manager, focused on using the best ideas from equity research put it well when he said, Good analysts always challenge what theyve been told or given.Over time, if a source of information proves accurate, let it into your circle of trust. If we include the financial press and everything distributed by companies, Id say at least 75 percent of the information out there for

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BestPracticesforEquityResearchAnalysts:EssentialsforBuySideandSellSideAnalysts

consumption by financial analysts is misleading or omits an important piece of information relevant to the topic. Herein lies the challenge: You need to determine which 25 percent is reliable and then, which portion of that is critical to your investment thesis. Very often, less than 2 percent of the available information will help make an investment decision that creates alpha. And that 2 percent of the information today wont likely be found in the same place as the 2 percent youll need in six months.
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Beyond sheer intelligence, properly prioritizing your time is the single biggest factor that separates the good from the great. We all have the same 24 hours per day to find the 2 percent of information that matters, but some have figured out how to use the time better than the rest. Its tough to beat the market. In doing so, dont look for shortcuts or quick answers as a substitute for thorough research, because they dont workat least not consistently. If they did, capital would be attracted to these easy moneystrategies until all of the alpha was captured. Fear is more powerful than greed, but they are both important to watch. When you see others becoming fearful, look for opportunities. When you see others becoming greedy, look for an exit. When it comes to the investment process, simplicity trumps complexity. The more complicated the model, catalyst, thesis, etc., the greater the likelihood something will go wrong. Forecasting is not as much about getting the exact EPS or revenue figure correct, but determining that expectations need to be raised or lowered materially (e.g., if your marquee reads, XYZ Likely to Earn $3.00when consensus is at $2.50, you have a winner, regardless of current valuations). For the most part, company management is not good at telling investors:

How well the economy will perform in the future, because their macro crystal ball is rarely better than anyone elses. When their companys revenue growth rate will slow or margins weaken, because management rarely spots the negative inflection points. (They will argue their bullish view with investors and sell-side analysts as theyre driving off the cliff.) Where the directions of commodities or currencies are headed. (Theres an entire industry of professionals dedicated to this 24/7, who are routinely challenged to get it right.)

Dont mistake news for research:

The media tends to hype things; dont forget that they get paid by advertisers who want to maximize eyeballs, not objectivity. To this end, data can be, and often is, misconstrued to meet the needs of the journalist. Experts in the press often arent; they may simply be the person who had time for an interview.

Hopefully, these truisms can serve as helpful guiding principles, but the challenges most analysts face also require thorough and often very specialized solutions. The material that follows has been developed and organized in an effort to help analysts efficiently reach those solutions by following the best practices of other successful practitioners.

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