In our last post, we noted that investors, aka the Buy Side, are becoming much more discriminating in their consumption of and payment for equity research. Today, the research model seems to be largely driven on a quantity-over-quality basis. This distorts the market for research and drives investors to drink with the amount of research they have to sift through every day. As investment funds move towards directly paying for research it seems likely that they will push for a model that more clearly rewards ‘valuable’ research.
So the question is what constitutes valuable research?
For many outside the industry (e.g. our parents), it would seem obvious. Good research is giving good stock advice – Buy Low, Sell High. The reality is much more complicated. Ultimately the burden is on investors to make the buy and sell decisions. Sell-side research analysts provide value in other ways. In this post we will walk through these.
First, is deep knowledge. The average fund manager has to keep track of 100-200 stocks. Over their career this universe likely turns over several times. So there is no way for them to get deep into the woods on all of their names. By contrast, sell-side analysts typically cover 20 – 30 companies. This gives them the ability to build long-term knowledge, this is a form of institutional memory. Experienced analysts know management teams, usually on a first-name basis. The analysts have probably gone through two or three generations of executives at the company’s they cover. So they remember past mistakes and should have a better understanding of the motivations behind the latest set of company decisions. In addition, since analysts tend to focus on narrow sectors, they can compare, contrast and recite industry basics fairly quickly. Done well, this is an invaluable resource for investors who need to quickly ramp up on a new sector.
Second, analysts can act as megaphones, amplifying a particular view of a stock. While there are too many analysts, they can still command an outsize share of attention from the press. Analyst views still matter to large audiences. Their ratings can move a stock. Investors who want to keep close tabs on how the broader market view a stock can do this by making a few quick analyst calls. Also, analysts talk to many investors daily, so they can provide the best overview of how the broader investment community views the latest developments at any particular company.
The most important mechanism for this amplifier are earnings estimates. Stocks react sharply each quarter when their actual results are published and compared to analysts’ estimates. Companies can deliver incredible growth and profitability but still see their stocks fall 10% after earnings because they were a few percent below ‘expectations’. There are all kinds of problems with this model, but we will not get into them here. Instead, our view is just that consensus estimates still matter tremendously. For the time being, sell-side analysts are the ones setting that consensus.
The corollary to this is that some more aggressive funds try to game the system and drive the Street’s opinion. There are some obvious ethical (and maybe legal) problems with this, but it is hard to pin down. Nonetheless, there are a handful of funds who know that by making a dozen aggressive phone calls, they can sway analysts on the fence in their particular direction. Analysts are always wary of investors ‘talking their own book’, but at the same time, it is hard to ignore a paying client. The funds that do this are typically among the largest commission payers at many brokers.
A third value driver is ‘corporate access’. This is one of those nebulous areas that will eventually get scrutinized more closely. The basic idea is that companies devote a considerable amount of their executives’ time to doing non-deal roadshows or attending conferences hosted by the brokers. Companies like to have analysts covering them. As noted, analysts can amplify a message, and so companies can use their executives to deliver the company message to that amplifier. So every quarter, companies devote a week or two of time to sending their executives out to meet with analysts’ clients. Analysts with good management relationships get more of these meetings. For their part, investors pay the analysts for those meetings.
Now to be clear, these are not shady meetings where management teams lay out all the next quarters’ details to this closed group of investors. Those meetings went away with REG FD 15 years ago. Nonetheless, investors still like to ‘look management in the eye’ when considering investing in their stock. In our experience, these meetings rarely disclose non-public information. But there is another problem with corporate access. Companies get to decide how to allocate their time, and they tend to favor analysts with positive opinions of their stock, and avoid those with negative opinions. At the very least, this provides a subconscious bias towards positive ratings.
The problem with the list above is that there are very few defensible business models involved. The ‘message amplification’ and ‘corporate access’ pieces can be done by any broker, the analyst really brings nothing to the table other than the relationship management with the company.
The only way that analysts can really differentiate themselves is by providing some form of scarce data. There are some analysts out there who have clever methods for collecting proprietary data sets, and these can be valuable. But they also tend to evaporate over time as others figure out how to replicate them. Far more sustainable is this ability to focus on a small number of companies and get to know them better than anyone else. There is value in that. We know one analyst who has become an expert in RF semiconductors. We think his stock calls are terrible, but that is beside the point, because he knows more about that corner of the industry better than anyone.
The downside in all of this is that if ‘deep knowledge and institutional memory’ are the basis for future research business models, then there are far too many analysts out there.