tjbresearch.com
Thursday, June 24th, 2010
those darn analysts

It is common to question the worth of Wall Street analysts.  Lately there have been quite a few grenades tossed in their direction, including one by Joshua Brown, who highlighted the bad calls on British Petroleum of late,The Reformed Broker | I posted a rather lengthy comment on the site in response. which was followed by one from Bloomberg, which revealed that “Wall Street’s lowest-rated stocks have turned into this year’s best performers.”Bloomberg | The article does a good job of presenting different perspectives about why and whether it matters.

Some notes:  There has been much academic work on the performance of analyst recommendations, which should form the foundation of any detailed discussion of these issues.  In addition, you might review my writings about the evaluation services that measure analyst performance, and the conclusions that you should or should not draw from the information.the research puzzle | The recent “yardsticks for pundits” includes links to three of my prior postings. A point to keep in mind is that surveys of institutional money managers consistently show that they don’t place much value on sell-side analyst recommendations.Integrity Research | This piece includes a listing from Institutional Investor that shows “stock selection” as dead last out of twelve things named that portfolio managers look for. The bottom line:  Far too much attention is paid to an exercise in futility that doesn’t really match up to the needs of investors; stock ratings are fodder for the media (thus the battle over theflyonthewall.com), but beyond that reveal little of what an analyst truly brings to the table.

My concerns lie elsewhere.  Think of what we ask analysts to do.  (I speak here of fundamental equity analysts, both sell-side ones, who pitch their ideas to institutions and individuals, and buy-side ones, who do the same within their own firms.)  While the job can be made to sound simple — to inform and aid decision makers in their choices — it involves quite an array of skills and duties.

To be successful, you need to be a business analyst that evaluates anything and everything.  The list of most important considerations varies by industry and company, but think of the pieces:  operations, sales, marketing, finance, etc.  Any of them can cause problems or improvements within a firm; how well do you understand the internal dynamics of each?

Often you are called on to be a technical expert.  Especially in areas like computing or biotech, you can be consumed by the details of the products.  At the margin, this can suddenly become a large part of your job; I dare say that analysts in the oil industry probably know a lot more today about blowout preventers than they did in March.

In addition, you must be an industry expert.   Not just in knowing the players and the news (and keeping up with the trade press, attending industry events, etc.), but in understanding the competitive dynamics of the industry and interrelated industries.  Plus, you can’t ignore the governmental and regulatory realities and risks.

You must be an astute judge of management talent.  In addition to being able to read a management well, you need to toe the line to make sure that you are close enough to make good judgments about the capabilities of the management team, but not too close to be taken in by the story they are trying to sell.  Assessing the governance structure for danger signs is part of the job too.

You need to dig into the numbers, serving as a de facto auditor of financial reports.  Many industries have specific accounting issues, there are new rules all the time, and age-old shenanigans that can only be found by mastering the details pop up now and again.

With all of this information in hand, you then put on the hat of a forecaster, keeping in mind all of the analytical and behavioral traps that come with it.

At some point, you pull all of this together to try to figure out what a stock is worth, playing your roles of modeler and valuation expert.  No matter how laughingly simple or maddeningly complex your approach, you have to have some way to assess value, and it’s usually more art than science.

You might spend some time understanding the particular supply and demand dynamics of the stock itself, rather than the company, although Josh Brown’s chief complaint referenced above is that almost no fundamental analysts ever do that.

Once you have all of that information processing done, it’s time to shift gears.  Yes, you need a set of conclusions.  If you are a sell-side analyst, you have to slap a simple rating on all of it and a target price too, for what that’s worth.  A buy-side analyst may get to paint a more rich picture of the possibilities, perhaps even being able to map a range of outcomes as a risk manager might.

Then comes the hard part for many.  It’s time to be a marketer of your ideas.  If you need to put them in readable form, you must be a writer (by the looks of most research reports, not the easiest thing), otherwise a salesperson, going office to office, or speaking to a group, or commenting on a squawk box, or even on television.

I have seen estimates that well over half of a sell-side analyst’s time is taken up with marketing duties.  Promoting your ideas takes time for analysts at asset management firms too, although nowhere near as much.  I have always been surprised, though, that many fine buy-side analysts fail because they aren’t good at communicating their ideas effectively.

Now, after all of that, I ask:  What are the chances that you are going to be good at this broad spectrum of responsibilities?  For one stock?  For twenty or forty?  Sure, you may have an assistant or even a team to bear some of the burden, but are they organized in a way that recognizes and emphasizes the key pieces of the research puzzle that you face?

It is time for a radical rethinking of the analyst role as now practiced.  In most investment organizations, we have made it too easy to say, “those darn analysts,” without stopping to realize that we have constructed a job that is unwieldy and unlikely to engender success.  Let’s go back to the drawing board.