What is Equity Research?

an investment advisory service

Three types of analysis: Fundamental AnalysisA method of
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evaluating a security by attempting to measure its intrinsic value by examining related economic, financial and

other qualitative and quantitative factors. 2 Attempt to study everything that can affect the security's value, including macroeconomic factors (like the overall economy and industry conditions) and individually specific factors (like the financial condition and management of companies). 3 Most sell-side analysts are perform fundamental analysis. They try to determine a specific asset value. (Overbought/Oversold) 4

Technical Analysis (Chartists)A

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method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. 6 Do not attempt to measure a security's intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity. 7

Quantitative Analysis (Quants)A method

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that seeks to understand behavior by using complex mathematical and statistical modeling, measurement and research. By assigning a numerical value to variables, quantitative

analysts try to replicate reality mathematically.

Research and the Stock Market Actually, the title of this article is a bit misleading because the role of research has not changed since the first trade occurred under the Buttonwood Tree on Manhattan Island. What has changed is the environments (bull and bear markets) that influence research. The role of research is to provide information to the market. An efficient market relies on information: a lack of information creates inefficiencies that result in stocks being misrepresented (over or under valued). Analysts use their expertise and spend a lot of time analyzing a stock, its industry and peer group to provide earnings and valuation estimates. Research is valuable because it fills information gaps so that each individual investor does not need to analyze every stock. This division of labor makes the market more efficient. Research in Bull and Bear Markets If the role of research has always been so "noble", why is it currently in such a state of ill-repute? There are two reasons: firstly the current bear market gives us a new perspective to evaluate the excesses of the last bull market; secondly investors need to blame somebody. In every bull market there are excesses that become apparent only in the bear market that follows. Whether it is tulips or transistors, each age has its mania that distorts the normal functioning of the market. In the rush to make money, rationality is the first casualty. Investors rush to jump on the bandwagon and the market over-allocates capital to the "hot" sector(s). The most recent examples being web-based grocery companies, online pet stores and fiber-optic capacity. This herd mentality is the reason why bull markets have funded so many "me-too" ideas throughout history. Research is a function of the market and is influenced by these swings. In a bull market investment bankers, the media and investors pressure analysts to focus on the hot sectors. Some analysts morph into promoters as they ride the market. Those analysts that remain rational practitioners are ignored, and their research reports go unread. During the late 1990s the business media catered to the audience's demands and gave the spotlight to the famous talking heads that are now under investigation. Seeking to blame someone for investment losses is a normal event in bear markets. It happened in the 1930s and the 1970s and is occurring today. Some of the criticisms are deserved, but the need to provide information has not changed. Research in Today's Market To discuss the role of research in today's market, we need to differentiate between Wall Street research and other research. Wall Street research is provided by the major brokerage firms (both on and off Wall Street). Other research is produced by independent research firms and small boutique brokerage firms.

This differentiation is important. First, Wall Street research has become focused on big cap, very liquid stocks and ignores the majority (over 60% based on our research) of publicly-traded stocks. This myopic focus on a small number of stocks is the result of deregulation and industry consolidation. In order to remain profitable, Wall Street firms have focused on big-cap stocks to generate highly lucrative investment banking deals and trading profits. Those companies that are likely to provide the research firms with a sizable investment banking deals are the stocks that are determined worth being followed by the market. The stock's long-term investment potential is secondary. The second reason to distinguish Wall Street from other research is that most of the blame for the excesses of the last bull market is rightfully placed on Wall Street. Other research is filling the information gap created by Wall Street. Independent research firms and boutique brokerage firms are providing research on the stocks that have been orphaned by Wall Street. Investors, now educated in the benefits of electronic trading, may not be willing to support boutique brokerage firms for their research by opening an account and paying higher commissions. This means that independent research firms are becoming the main source of information on the majority of stocks, but investors are reluctant to pay for research because they don't really know what they are paying for until well after the purchase. Unfortunately not all research is worth buying. I have purchased reports from reputable sources only to find them inaccurate and misleading. Who Pays for Research? Big Investors Do! The ironic thing is that while research has proven to be valuable, individual investors do not seem to want to pay for it. This may be because, under the traditional system, brokerage houses provided research in order to gain and keep clients. Investors just had to ask their brokers for a report and retained it at no charge. What seems to have gone unrealized is that the commissions pay for that research. A good indicator of the value of research is the amount institutional investors are willing to pay for it. Institutional investors hire their own analysts to gain a competitive edge over other investors. They also pay (often handsomely) independent research firms for additional research. Institutions also pay for the sell-side research they receive (either with dollars or by giving the supplying brokerage firm trades to execute). All this amounts to big money, but the institutions realize that research is integral to making successful investment decisions. If investors are unwilling to buy research how will the market correct the imbalance caused by the lack of coverage? The solution may be found by looking at the issue a slightly different way. The Growing Role of Fee-Based Research Fee-based research increases market efficiency and bridges the gap between investors

who want research (without paying) and companies who realize that Wall Street is not likely to provide research on their stock. Fee-based research provides information to the widest possible audience at no charge to the reader because the subject company has funded the research. It is important to differentiate between objective fee-based research and research that is promotional. Objective fee-based research is analogous to the role of your physician. You pay a physician not to tell you that you feel good but to give you his or her professional and truthful opinion of your condition. Legitimate fee-based research is a professional and objective analysis and opinion of a company's investment potential. Promotional research is short on analysis and full of hype. An example is the fax and email reports about the penny stocks that will supposedly triple in a short time. Legitimate fee-based research firms have the following characteristics: 1. They provide analytical not promotional services. 2. They are paid a set annual fee in cash; they do not accept any form of equity, which may cause conflicts of interest. 3. They provide full and clear disclosure of the relationship between the company and the research firm so investors can evaluate objectivity. Companies who engage a legitimate fee-based research firm to analyze their stock are trying to get information to investors and improve market efficiency. Such a company is making the following important statements: 1. That it believes its shares are undervalued because investor are not aware of the company. 2. That it is aware that Wall Street is no longer an option. 3. That it believes that its investment potential can withstand objective analysis. Perhaps more importantly, the reputations/credibility of the company and the research firm depends on the efforts they make to inform investors. A company does not want to be tarnished by being associated with disreputable research. Similarly, a research firm will only want to analyze companies that have strong fundamentals and long-term investment potential. Fee-based research has had to fight the stereotype of promotional research, but the market is starting to realize that fee-based research is a viable source of information. The National Investor Relations Institute (NIRI) was probably the first group to recognize the need for fee-based research. In January 2002 NIRI issued a letter emphasizing the need for small-cap companies to find alternatives to Wall Street research in order to get their information to investors. More recently, the NIRI is conducting a survey on research alternatives and will possibly have a session on this topic at their national conference this year.

Asset class If one were to poll investors and investment professionals to determine their ideal investment scenario, the vast majority would no doubt agree it is a double-digit total return in all economic environments, each and every year. Naturally, they would also agree that the worst-case scenario is an overall decrease in asset value. But despite this knowledge, very few achieve the ideal and many encounter the worst-case scenario

Managing risk and diversification The reasons for this are diverse: misallocation of assets, pseudodiversification, hidden correlation, weighting imbalance, false returns and underlying devaluation. The solution, however, could be simpler than you'd expect. In this article we'll show how to achieve true diversification through asset class selection, rather than stock picking and market timing.
The Importance of Asset Class Allocation Most investors, including investment professionals and industry leaders, do not beat the index of the asset class in which they invest, according to two studies by Brinson, Beebower et al entitled "Determinants of Portfolio Performance" (1986) and "Determinants of Portfolio Performance II: An Update" (1991). This conclusion is also backed up in a third study by Ibbotson and Kaplan entitled "Does Asset Allocation Policy Explain 40%, 90% or 100% of Performance?" (2000). Which begs the question, if a U.S. equities growth fund does not consistently equal or beat the Russell 3000 Growth Index, what value has the investment management added to justify their fees? Perhaps simply buying the index would be more beneficial. Furthermore, the studies show a high correlation between the returns investors achieve and the underlying asset class performance; for example, a U.S. bond fund or portfolio will generally perform much like the Lehman Aggregate Bond Index, increasing and decreasing in tandem. This shows that, as returns can be expected to mimic their asset class, asset class selection is far more important than both market timing and individual asset selection. Brinson and Beebower concluded that market timing and individual asset selection accounted for only 6% of the variation in returns, with strategy or asset class making up the balance.

Figure 1: A breakdown of factors that account for variation in portfolio returns

Broad Diversification Across Multiple Asset Classes Many investors do not truly understand effective diversification, often believing they are fully diversified after spreading their investment across large caps, mid or small caps, energy, financial, healthcare or technology stocks, or even investing in emerging markets. In reality, however, they have merely invested in multiple sectors of the equities asset class and are prone to rise and fall with that market.

If we were to look at the Morningstar style indexes or their sector indexes, we would see that despite slightly varying returns, they generally track together. However, when one compares the indexes as a group or individually to the commodities indexes, we do not tend to see this simultaneous directional movement. Therefore, only when positions are held across multiple uncorrelated asset classes is a portfolio genuinely diversified and better able to handle market volatility as the high-performing asset classes can balance out the under performing classes. Hidden Correlation An effectively diversified investor remains alert and watchful, because correlation between classes can change over time. International markets have long been the staple for diversification; however, there has been a marked increase in correlation between the global equity markets. This is most easily seen among the European markets after

the formation of the European Union. In addition, emerging markets are also becoming more closely correlated with U.S. and U.K. markets. Perhaps even more troubling is the increase in what was originally unseen correlation between the fixed income and equities markets, traditionally the mainstay of asset class diversification. It is possible that the increasing relationship between investment banking and structured financing may be the cause for this, but on a broader level, the growth of the hedge fund industry could also be a direct cause of the increased correlation between fixed income and equities as well as other smaller asset classes. For example, when a large, global multi-strategy hedge fund incurs losses in one asset class, margin calls may force it to sell assets across the board, universally affecting all the other classes in which it had invested.

Class Realignment Ideal asset allocation is not static. As the various markets develop, their varying performance leads to an asset class imbalance, so monitoring and realignment is imperative. Investors may find it easier to divest underperforming assets, moving the investment to asset classes generating better returns, but they should keep an eye out for the risks of overweighting in any one asset class, which can often be compounded by the effects of style drift

An extended bull market can lead to overweighting in an asset class that may be due for a correction. Investors should realign their asset allocation at both ends of the performance scale.

Relative Value Asset returns can be misleading, even to a seasoned investor. They're best interpreted relative to the performance of the asset class, the risks associated with that class and the underlying currency. One cannot expect to receive similar returns from tech stocks and government bonds, but one should identify how each fits into the total investment holding. Effective diversification will include assets classes of varying risk profiles held in various currencies. A small gain in a market with a currency that increases relative to your portfolio currency can outperform a large gain in a retreating currency - and, likewise, large gains can become losses when converted back to a strengthened currency. For evaluative purposes, the investor should analyze the various asset classes in relation to their "home currency" and a neutral indicator. (For a detailed breakdown of this effect, check out The Impact Of Currency Conversions.)

The Swiss franc, which has been one of the more stable currencies since the 1940s with relatively low inflation, can be one benchmark against which to measure other currencies. For 2007, the S&P 500 was up roughly 3.53%. However, when factoring in the American dollar's devaluation against most currencies in the same year, investors would effectively experience a net loss. In other words, an investor who chose to sell his or her entire portfolio at the end of 2007 would get more U.S. dollars than one year previously - but the investor could buy less with those dollars than the year before relative to other foreign currencies. When the home currency devalues, investors often ignore the steady decrease of their investments' buying power, which is similar to holding an investment that yields less than inflation. Conclusion All too often, private investors become bogged down with stock picking and trading activities that are not only time-consuming, but can be overwhelming. It could be more beneficial - and significantly less resource-intensive - to take a broader view and concentrate on the asset classes. With this macro view, the investor's individual investment decisions are simplified, and they may even be more profitable.