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The Death Of Equity Research Hasn't Been Greatly Exaggerated

Authored by James Valentine via Inegrity-Research.com,

From my vantage point, the career prospects for Equity Research analysts look dismal.  The decade-long shift from active to passive management isn’t new, but it appears to be reaching a tipping point as seen in the rash of announcements from high-profile buy-side and sell-side firms closing their doors, merging or outsourcing to bots.

I’m not sure if we should be more troubled by the fact that so little is being done within our industry to fix the problem or by the lack of acknowledgement there even is a problem.  I don’t claim to have all the answers, but I can see one major dilemma leading to our demise.  Clients are asked to pay 1%-2% active management fees because “Research is in our DNA” and “Research defines us and distinguishes our firm” (direct quotes from sell-side and buy-side marketing content) and yet I find over 80% of analysts are relying almost entirely on company management for their financial forecasts (or relying on the sell-side, who too often rely primarily on company guidance).

How can we tell our clients we can consistently beat passive indexes if everyone is using company guidance to drive our collective thought process? There are thousands of buy-side firms that pay $1,000 to $10,000 to take a single meeting with company management during non-deal roadshows and yet most of these firms don’t have a budget or a process to rigorously develop an independent view for the stocks being researched.  Moreover, I find too many analysts “covering” well over 50 stocks, stretched too thin to consistently derive out-of-consensus insights.

The simple truth is if we’re going to ask clients to pay us 1%-2% of AUM for “excess” or “abnormal” returns, we need to spend an excessive amount of time seeking insights from abnormal sources (not just company management and the sell-side).

Identify Unique Sources of Insights for 1-4 Critical Factors

Finding good, unique and informed information sources is very, very difficult to do, which is why I suspect so few analysts have them.  So before setting out on this journey, it’s critically important to identify the 1-4 critical factors likely to cause a stock to out- or under-perform (the #1 goal of an analyst) and then stick to finding experts who can help in these areas.  For example, the release of Apple’s next iPhone is undoubtedly one of the stock’s few true critical factors, with the key assumptions to be answered “will the features be enough to entice current users to upgrade?” and “will it be priced above or below current levels?”  I find the best analysts stay laser focused on seeking only those sources that can answer these two questions because everything else is wasted time chasing noise (e.g. understanding the company’s tax problems with the EU or the next iteration of the Apple Watch are not going to result in a major move in the stock).

After the 1-4 critical factors are identified (and only after they’re identified), it’s critical to get informed insights from sources such as these below:

  • Consultant, expert, or company retiree
  • Management from customer of, or supplier to, or competitor of the stock being researched (can be publicly-traded or privately-held company)
  • Government official, staffer, lobbyist or association executive
  • Journalist, blogger or noted book author
  • Industry award-winners (e.g. best salesperson)

Eliminate Distractions

While the unique sources discussed above are critical to success, analysts won’t have time to find these sources without first-rate time management skills.  Equity research analysts have one of the most unstructured jobs in the world.  Ask your doctor how many patients can be seen in a day and then ask an equity research analyst “how many stocks can be researched in a day?”  Given the nature of research, our job is never done which is why it’s so important to have superb time-management skills.

Time management partly involves focusing on activities that will yield the greatest results:

  • Maximize “offensively-focused” activities where proprietary insights are most likely to be found. Examples include:
    • Making outgoing phone calls to information sources who offer insights that improve the forecasting of critical factors
    • Participating in private or small group meetings with industry expert(s) or management of competitors of the company being researched
    • Attending an industry conference where few financial analysts are in attendance
    • Review only what’s changed (e.g. Bloomberg’s Redline and FactSet’s Blackline for quarterly reports)
  • Minimize “defensively-focused” activities such as those that may provide background but not alpha-generating insights. Examples include:
    • Quarterly earnings conference calls (reading the transcript can be done in half the time as listening to the call)
    • Reading entire regulatory filings
    • Sell-side-sponsored investor conferences (only attend if one-on-ones are available)
    • Site tour, especially when no senior management are present (if the tour doesn’t cover a potential critical factor, spend time elsewhere)
  • Participate in calls/meetings only when they directly pertain to the critical factors for stocks of interest.

Conclusion

I wish I could say the future looks bright for equity research, but few professionals appear to be addressing the miserable under-performance plaguing our industry and so there’s no reason to expect the drain of actively-managed assets to stop.  If the industry’s key players wake up to this problem, we have plenty of intelligent, hard-working professionals to get us back on track, which I suspect will include identifying better sources of insight and using time more wisely.