Insider series: the value of stock market research, part I

Posted by on April 22, 2009 in Insider Series

Welcome to my periodic insider series posts where I explore a topic in depth with some experts. Today’s insider series is part one of  a 3 way conversation between Brad from Triaging My Way to Financial Success , Preet from Where Does All My Money Go and myself about the topic of stock market research.

Just as a word of warning, these posts are extremely long (this post alone clocks in at 2700 words). For readability, I have alternated between normal text and italics. For shorthand, Brad is NurseB911, Preet is WDAMMG and I am TMW. Enjoy.

INTRODUCTION

TMW: Brad, let’s start with you since the genesis of this conversation is your SAML program which is making its way through the blogsphere. Tell me about it.

Nurseb911: The SAML (Stock Analysis Mailing List) is a subscription program I launched in January of 2009. Many readers over the past two years have enjoyed the various stock analyses I’ve published for free on my website. Often I took a rather tame approach to the analysis to discuss some background on the company, its investing prospects and various operational strengths that I felt could benefit a company in the future. In my private business, Triage Capital Management Inc., I conduct an analysis for clients on their business plans that bring together a wide range of topics including a situational analysis, competitive analysis, market analysis and strategic management.

Whenever I begin to research a company I want to invest in, say Coca-Cola (KO), I write one of these same styled reports in order to establish an understanding of the company’s current investment potential. I apply a series of the self developed Value Rules that I’ve derived from my own business/investing experiences and critically analyze a number of important criteria. I also update important information on all the companies I own or maintain on my watchlist over a period of time in order to get the best picture of a company’s current investment status: are earnings growing, are costs under control, has their target market changed, do they care about margins, how competent is their senior management, etc.

Essentially this program is a stock analysis tool that readers can use to learn how I conduct my analysis for any prospective investment. I have 41 free subscribers who use the program for various purposes; with some readers never intending to own the stock but acknowledge will use the analysis as a tool or template for learning how to examine another company. Alternatively non-subscribers can purchase the full analysis, after reading the public version I post on my site, if they are interested in the company or already own it.

HOW FREE IS RESEARCH?

Your program has been highlighted in Canadian Dream and Four Pillars and there appears to be push back to your research that I can be separated into two large categories:

  1. Why do I need this research if my broker is already providing this and
  2. Why should I trust your research?

Let me address the first pushback first- why you over, say, research provided by an on-line broker?

Nurseb911: It’s first important to realize a few things. Analyst reports and research provided by your broker are not free; the brokerage has paid for those reports in part with the commissions and fees it generates from your investing activities. Some reports are provided as a free service to investors, but for the most part these reports are quite expensive when you consider how high your trading costs are and how low the interest on cash balances is in your account. It doesn’t cost a company $19.99 to execute an electronic trade with today’s technology so where is that high cost coming from?

TMW: Preet- can you give me some insider views of the research department’s interaction with the retail sales force? As I understand it, analysts, with some notable expectations, are paid towards the bottom of the food chain in investment bankers relative to the sales staff. How does it work on the inside?

WDAMMG: The retail sales force (advisors) are profit centres. The analysts are cost centres. At a full service brokerage, the advisors have direct number access to the analysts. If a client had specific questions about certain companies the advisor can either call up the analyst for a detailed discussion, or even arrange a conference call with the client if need be. Many research reports publish the phone number of the analyst right under their name, you could just call them up too – my guess is that if you are asking the right questions, many of them would be happy to give you their insights. Phone calls with analysts usually lasted about 30 seconds to 2 minutes in my experience.

Analysts can earn big bucks. Before I actually got into the industry the original plan was to become a bio-tech stock analyst (I have a background in Neuroscience). My mentor at the time knew one of the higher rated bio-tech stock analysts on Bay Street and her income was close to the 7 figure range. You certainly have to put your time in before you get to those kind of levels, and you also need a certain amount of “celestial alignment” in the form of strong markets and strong relative performance. Analysts rank pretty high on the income side with respect to the average retail sales force I would say. You usually find one analyst per sector per shop (who in turn have a number of research associates). Analysts supporting a full service brokerage will have their research trickle down to the various different retail business lines (i.e. all the way down to the discount brokerages).

TMW: Preet, if analysts are indeed cost centres then and not the front line sales people, how do we make the leap from research for informational purposes to research for sales purposes? There’s something bridging that leap from informational- albeit completed for a sales purpose-to sales.

WDMMG: Well I think you have to take it all with a grain of salt. Over time roles have evolved. There was a time (still exists to a certain degree) where an investment bank’s sales force (in this case: the investment bankers who are facilitating primary market operations to raise capital for their clients who are businesses looking for money) pressured the research department to suit their purpose. At the very least it’s a conflict of interest. If you were leading a marketed deal, for example, your efforts would be helped by rosy research on the company. Conversely, I don’t think it’s a stretch to imagine that an analysts’ research report with high valuations has lured a business into securing an investment bank as their agent – think of a real estate agent who says they can sell your house for 10% more than anyone else. It’s tempting. Along the way, investment banks and full service brokerages have over time merged and grown into multi-business line financial services providers. Maybe I’m jaded, but research for information purposes never existed ubiquitously.

I should note that there are some analysts and analyst firms who just sell research and are not affiliated with investment banking operations or a retail sales force, but as far as I know, they are the exception.

IS RESEARCH A SALES TOOL?

TMW: So the question is, is it actually the analysts’ reports that are at fault or how they are packaged? I have to rely on some insider information myself since I have a few friends who work on the operational part of investment banks and they grumble that they read balanced research in which the sales department scratches out the downside risk and attempts to sell on upside- so is it the research per se or how it is presented? Preet, having been on front line sales staff before, why don’t you start?

WDAMMG: The use of research reports for the retail sales force is as follows. An advisor would sift through research reports based on the universe of stocks they actively follow (or clients hold or ask questions about). Research reports will generally have a 1 year target price for the stock in question which is based on all the available information in the market and the analysts’ proprietary valuation models. In many cases, an advisor would quote the target price first and foremost and then present a story, or thesis, which is also found in the research report. There are advisors out there who do their own research and compare and contrast with the analysts, but the majority rely on the research without second guessing it too much. One of the problems is that not many people properly frame the use of price targets (and the shortfalls). So as I said before, a target price is based on the assimilation of all known information thrown into a valuation model that is pretty much proprietary to the analyst or analyst team. The problem is that “all known information” does not mean “all information”. There’s a lot of unknown information. “Research reports serve to narrow the range in which we guess” is the better way of framing it, but how likely is it that a salesperson would use that tactic?

But that’s just my two cents. What’s your take Brad?

Nurseb911: I have no doubt that many analysts are honest, smart and good intentioned individuals. The problem I have with analyst reports and recommendations is that their purpose is to influence a target market (investors) to buy, sell or hold a stock. Analysts create reports in order to affect the behaviours of investors and not for educational purposes. No analyst report that I’ve ever read mentioned what important components of a qualitative assessment produced the company’s current quantitative results. The question of a conflict of interest is therefore a very important consideration for an investor who reads an analyst report or recommendation. If you don’t stand to gain a greater benefit from the information being provided then someone else is benefiting at the expense of your money. For an industry with an already established lack of transparency, reliability and open disclosure I think investors should be conscious and active in questioning how significant any established conflicts of interest are.

I don’t want to necessarily want to point fingers at who is at fault, but clearly the current model doesn’t benefit the investor more than the individuals writing or selling the reports. Sales people have to make money to live, but they’re paid very good money to offer an opinion which should be unbiased at best. Weeding out risk in an attempt to provide a compelling selling thesis doesn’t seem ethical or prudent for an industry already under the microscope of investors.

The research isn’t as balanced as it needs to be on operating fundamentals and I think that’s one of my biggest concerns. Far too often they’re spending time on profitability without addressing how those profits came to be and what operating fundamentals (qualitative factors) are going to protect profitability in the future. Commodities are a perfect example as everyone jumped on the bandwagon promoting buy recommendations on everyone who had metals in the ground. The problem was that costs were rising, supply was increasing from all the investment during the past 4 years and as demand slowed considerably a lot of these investments with high debt levels crashed 50-80%.

Adding to the conflict of interest is the significant groupthink that the industry suffers from. I don’t need to tell investors how often an analyst will recommend a stock as a buy, sell or hold only after something important has happened to affect the stock price positively or negatively. These professionals should be able to give better clarity to future developments and the impact of current fundamentals than looking to past earnings growth and profitability for future trends. If I’m going to pay for something I want to make sure that an analyst is proactive versus reactive on identifying the problems inside a business that I intend to invest in.

TMW: I think what you are getting at here is look at the source of the research. Groupthink is nothing more than symptomatic of any industry that consolidated like the financial institutions. As the old saying goes in business “no one every got fired for hiring IBM”- the modern equivalent is no one ever got fired for following the advice of Goldman Sachs and if a GS analyst said buy Citigroup, and I was an analyst at Merrill Lynch, I want to make sure I am saying the exact same thing since we are both chasing the same group of clients and don’t want to upset them with less than a rosy analysis.

Brad- I do feel that you are painting an overly broad picture of the analyst industry. Meredith Whitney first warned about Citigroup in 2007 while she was with Oppenheimer & Co.- a pretty white shoe Wall Street firm and she has continued to be critical of the financial industry since she has formed an independent research shop. Veritas – one of those independent shops Preet alluded to earlier- is a very good independent analyst shop which has criticized banks in the past- they have some outstanding research based on forensic accounting disciplines.

However, the better research comes from shops who are basically research shops only and do not have to feed the “sales” master sort of speak. It is also interesting to note that Whitney has become famous because she is not your typical Wall Street analyst- she’s female and relatively young- in other words, not another old white guy. My point being that if they are selling research and not trying to coax sales as well, the research tends to be freer, but not completely, without a conflict of interest. Let’s face it. They are in business and no one wants to buy from Dr. Doom but no one wants a Pollyanna researcher either who is a mouth piece for the sales department. It important to check your source of research.

Nurseb911: Whitney is a rare breed of analyst who has made a career of going against the groupthink of the business community. She doesn’t represent the majority and investors can learn a lot at times from looking at opposing views of certain stocks to gain a better sense of what risks a company is exposed to.

TMW: I do agree with you that Whitney is the exception rather than the rule. I think the lesson to be learned is get research from different sources; the opinions of big shops may be similar- the whole groupthink approach- but there may be some nuggets from boutiques which mainstream may not pick up on (sounds like business media vs. financial blogs!).

QUALITY OF RESEARCH

TMW: Let’s move on from the source of research to the quality of research. What about the argument that large institutional firms have access to CEO’s and CFO’s and, as a result, their research should be “better” since they hear it from the horse’s mouth (sort of speak)?

Nurseb911: I’m a firm believer that actions speak louder than words. Ask investors how many times they heard a CEO or CFO announce that a dividend was safe in the past twelve months only to later find out that their quarterly income from that company is now 50% less or more. It’s a question of perspective. If an analyst hears about a strategic initiative that will increase profitability likely their first reaction will be the impact on earnings. My first question is always, “Is this initiative practical?” Can the new initiative be implemented, make a difference and does the company’s management have the capabilities to do so?

Any CEO or CFO can dangle candy in front of an investor because they are polished corporate politicians. They receive training in public relations, sell ideas to the Board of Directors and are the face of the company. I’m more concerned with looking past all the talk to the actions or inactions of management.

WDAMMG: It’s very true that CEOs and other executives can roll out the red carpet when, say, a Fidelity analyst or fund manager calls as opposed to a small player. Part of this is due to the fact that institutional investors (like a mutual fund manager) can control a large portion of a company. They command significant voting power.

(part 2 tomorrow discusses, among other things, what research investors should conduct themselves)

10 Comments on Insider series: the value of stock market research, part I

By Nurseb911 on April 22, 2009 at 8:01 am

Looks great TMW. Thanks for giving Preet & I the opportunity to participate in this discussion.

By Shank on April 22, 2009 at 9:53 am

Just a quick note (clearly you knew i’d show up with this topic). Coming directly from the inside as part of an analyst team, i thought i’d comment on the following quote:

“…not for educational purposes. No analyst report that I’ve ever read mentioned what important components of a qualitative assessment produced the company’s current quantitative results.”

A key point i want to make is that the analyst reports are educational for current and future events, but they do not strive to educate the potential investor on past events that lead to the current results (the exception being if the past event was last quarters just released earnings). The lack of education on how the company came to be happens for two main reasons: 1) Analyst reports are produced for the institutional investor crowd not the retail crowd. With this target market in mind, the Institutional investors do not care how the company came to be because 2) You can find all past how the current profits came to be by going through the annual and quarterly earnings reports, the MD&As, the AIFs, and any prospectuses and any buy side firm worth its money would have already done their own proprietary background analysis and would understand the company.

The sell side does produce one single report however that contains all the background of the company, the industry, the markets, its strategy, its structure etc. that does clarify how the company came to be and that is the initiating report. Once that document is published, shorter notes detailing current events gets published from there on and these reports do not tend to rehash ideas and education commented on during the initiating report.

sorry for the long winded post. just sharing another perspective. Cheers.

By Increasing market efficiency with insiders « Silicon Prairie on April 22, 2009 at 3:21 pm

[...] by siliconprairie under Uncategorized No Comments  While reading Thicken My Wallet’s interview about stock analysts with two other bloggers, I was reminded of some of the changes in the investment industry over the [...]

By admin on April 22, 2009 at 6:36 pm

Shank- thanks again for the comment and the insight. My question to you is what due diligence are buy-side doing that an analyst does not or is the due diligence exactly the same?

By WhereDoesAllMyMoneyGo.com on April 22, 2009 at 11:20 pm

Thanks for all your hard work in putting this series together – always a blast to participate in. Thanks to Brad too! Cheers.

By Indexing and Options, and The Value Of Stock Market Research : WhereDoesAllMyMoneyGo.com on April 22, 2009 at 11:25 pm

[...] Triaging My Way To Success and we are discussing some of the aspects of stock market research.  Part I is up and live and you can read it by clicking here, and Part II appears tomorrow (which may be today by the time you are reading this…). Share [...]

By Thicken My Wallet » Blog Archive » Insider series: the value of stock market research, part II on April 23, 2009 at 2:01 am

[...] Comments admin on Insider series: the value of stock market research, part IIncreasing market efficiency with insiders « Silicon Prairie on Insider series: the value of [...]

By Shank on April 23, 2009 at 8:42 am

The due diligence is essentially the same. The buy side takes it further by looking at the potential investment in the context of their current portfolio (i.e how it fits into the sum of the parts). The sell-side looks at the potential investment on a one off basis, relatively speaking.

Generally, the buy side spends more time working top-down rather than bottom up, so the bulk of due diligence is building proprietary models that helps build a short list of potential investments. Sell side works more bottom up (i.e. you’re going to cover a company so then you look at the macro picture and how it will effect the key drivers of the company).

By A Lap Of The Blogs : WhereDoesAllMyMoneyGo.com on April 23, 2009 at 10:15 pm

[...] Brad from Triaging My Way to Financial Success and myself about the value of stock market research. Part I here, and Part II [...]

By This and That: Bank of Canada Cuts Rates Again — Canadian Capitalist on April 24, 2009 at 7:43 am

[...] My Wallet conducted a two-part, three-way conversation with Preet of Where Does All My Money Go? and Brad of Triaging My Way To Financial Success on the [...]

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