Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts

BEST PRACTICES FOR EQUITY RESEARCH ANALYSTS

Essentials for Buy-Side and Sell-Side Analysts

JAMES J. VALENTINE, CFA

Copyright © 2011 by James J. Valentine. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher.

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To Emma, Laura, Alice, and Robert for their loving support.

If we knew what it was we were doing, it would not be called research, would it?

—Albert Einstein

Contents

List of Exhibits

Preface

Acknowledgments

Introduction

Chapter 1. Do You Have What It Takes to Be a Successful Analyst?

Part 1: Mastering Organization and Interpersonal Skills

Chapter 2. Take Control to Optimize the Coverage Universe

Chapter 3. Prioritize Time for the Most Valuable Activities

Chapter 4. Influence Others to Accumulate Insights and Get Heard

Chapter 5. Construct and Organize an Information Hub

Chapter 6. Buy-Side Only: Maximize Benefits of Sell-Side Relationships

Part 2: Generating Qualitative Insights

Chapter 7. Identify Factors That Impact a Sector’s Valuation and Performance

Chapter 8. Identify and Monitor a Stock’s Critical Factors

Chapter 9. Create Sustainable Proprietary Sources of Insight

Chapter 10. Get the Most from Interviewing for Insights

Part 3: Generating Quantitative Insights

Chapter 11. Detect Deceptive Numbers

Chapter 12. Leverage Statistics for Insights

Chapter 13. Conduct Surveys to Acquire Unique Insights

Chapter 14. Identify Yellow Flags through Forensic Accounting

Chapter 15. Identify the Relevant Microsoft Excel Features for Equity Research Analysts

Chapter 16. Creating the Best Spreadsheet Architecture for Financial Analysis

Chapter 17. Develop Company Financial Models to Elicit Insights

Chapter 18. Forecast Scenarios for the Most Important Critical Factors

Part 4: Mastering Practical Valuation and Stock-Picking Skills

Chapter 19. Understand the Benefits and Limitations of Common Valuation Methodologies

Chapter 20. Overcome Challenges to Creating Discerning Stock Calls

Chapter 21. Avoid Common Psychological Challenges That Impede Sound Investing

Chapter 22. Leverage Technical Analysis to Improve Fundamental Analysis

Part 5: Communicating Stock Ideas So Others Take Action

Chapter 23. Create Content That Has Value

Chapter 24. Identify the Optimal Communication Channels

Chapter 25. Convey the 7 Critical Elements of Stock Recommendations

Chapter 26. Special Considerations for the Most Important Delivery Channels

Part 6: Making Ethical Decisions

Chapter 27. Identify and Resolve Ethical Challenges

Works Cited

Index

List of Exhibits

Exhibit I.1: Primary Tasks of an Equity Research Analyst

Exhibit 2.1: Best Practice (Skills): Take Control to Optimize the Coverage Universe

Exhibit 3.1: Time Allocation for Buy-Side and Sell-Side Analysts

Exhibit 3.2: Automate, Delegate, or Outsource Decision Tree

Exhibit 3.3: Best Practice (Knowledge): Time Parameters for Conversations and Meetings

Exhibit 3.4: Best Practice (Skills): Time Management Tips for Equity Research Analysts

Exhibit 4.1: Best Practice (Knowledge): Understand the Key Skills Required for Influencing Others

Exhibit 5.1: Best Practice (Knowledge): Key Information to Collect

Exhibit 5.2: Pros and Cons to Notetaking Options

Exhibit 5.3: Best Practice (Skills): Construct and Organize an Information Hub

Exhibit 6.1: Best Practice (Skills): Buy-Side Only—Screening Sell-Side Research

Exhibit 6.2: Sell-Side Skills and Knowledge as Prioritized by Buy-Side Clients

Exhibit 6.3: Best Practice (Skills): Maximize Benefits of Sell-Side Relationships

Exhibit 7.1: Food Chain Analysis for U.S. Railroad Sector

Exhibit 7.2: Best Practice (Skills): Identify Factors That Impact a Sector’s Valuation and Performance

Exhibit 8.1: Forward-Looking Relative P/E Ratios for Major Railroads Operating in the United States (relative to the S&P 500)

Exhibit 8.2: Best Practice (Knowledge): Questions to Investigate before or during Interviews with Management

Exhibit 8.3: Best Practice (Knowledge): Documents to Review before Interviewing Management

Exhibit 8.4: Best Practice (Skills): Flow Chart of Ongoing Activity for Identifying a Critical Factor

Exhibit 8.5: Best Practice (Skills): Identify and Monitor a Stock’s Critical Factors

Exhibit 9.1: Best Practice (Knowledge): Time and Cost for Information Sources (ranked from lowest to highest based on typical cost)

Exhibit 9.2: Best Practice (Skills): Assessing and Approaching Information Contacts

Exhibit 9.3: Best Practice (Skills): Keeping the Right Distance with Company Management

Exhibit 9.4: Best Practice (Skills): Network within Your Firm

Exhibit 10.1: Best Practice (Skills): Create Interview Questions That Will Get Answers

Exhibit 10.2: Best Practice (Skills): Lead an Interview to Obtain Insights

Exhibit 10.3: Best Practice (Knowledge): Observing Body Language to Detect Deception

Exhibit 11.1: Best Practice (Knowledge): Spotting the Top 10 Deceptions When Presented with Data

Exhibit 12.1: Best Practice (Knowledge): Considerations When Comparing Data Series

Exhibit 12.2: Scatterplot with No Association

Exhibit 12.3: Scatterplots Where Association Exists

Exhibit 12.4: Quarterly Intermodal Revenue

Exhibit 12.5: Examples of Scatterplots

Exhibit 12.6: Scatterplot and Regression Line for Intermodal Revenue and Manufacturing Index

Exhibit 12.7: Regression Output for Log of Durable Manufacturing and the Log of Intermodal Revenues

Exhibit 12.8: Scatterplot and Regression Line for Log Intermodal Revenue and Log Manufacturing Index

Exhibit 12.9: Residuals from Regression

Exhibit 12.10: Regression Output for Lagged Values of the Log of Durable Manufacturing and the Log of Intermodal Revenues

Exhibit 12.11: Residuals from Regression

Exhibit 12.12: Output for Freight Revenue versus Expense Line Items

Exhibit 12.13: Best Practice (Skills): Use Regression Analysis to Improve Forecasting

Exhibit 13.1: Example Cover Page for Online Survey

Exhibit 13.2: Best Practice (Skills): Conduct Surveys to Acquire Unique Insights

Exhibit 14.1: Best Practice (Skills): Spotting Accounting Yellow Flags

Exhibit 15.1: Best Practice (Knowledge): Relevant Excel Features for Equity Research Analysts

Exhibit 15.2: Best Practice (Knowledge): Useful Excel Keyboard Shortcuts

Exhibit 15.3: Best Practice (Knowledge): Most Relevant Excel Functions and Formulas for Equity Research Analysts

Exhibit 16.1: Best Practice (Skills): Creating the Best Spreadsheet Architecture for Financial Analysis

Exhibit 17.1: Best Practice (Knowledge): Elements of a Good Company Model

Exhibit 17.2: Sources for Company Financial Models

Exhibit 17.3: Modeling Considerations Unique for Value versus Growth Companies

Exhibit 17.4: Best Practice (Skills): Develop Company Financial Models to Elicit Insights

Exhibit 18.1: Best Practice (Skills): Creating Forecast Scenarios in Excel

Exhibit 19.1: Best Practice (Knowledge): Benefits and Limitations to the Most Common Valuation Methodologies

Exhibit 19.2: Best Practice (Skills): Rigorously Develop an Appropriate Valuation Multiple

Exhibit 20.1: Best Practice (Skills): Exploit Flaws in Market Sentiment to Enhance Stock Picking

Exhibit 20.2: Best Practice (Knowledge): Factors to Monitor to Understand Market Sentiment

Exhibit 20.3: Best Practice (Skills): Build a Comp Page to Identify Stocks with the Most Upside and Valuation Outliers

Exhibit 20.4: Best Practice (Knowledge): Appreciate Lessons Learned from Experienced Stock Pickers

Exhibit 20.5: Best Practice (Knowledge and Skills): Ensuring Success as a Stock Picker

Exhibit 21.1: Investor Personalities

Exhibit 21.2: Best Practice (Knowledge): Most Common Psychological Pitfalls of Investment Professionals

Exhibit 22.1: Explanation of Candlestick Chart

Exhibit 22.2: Example of Candlestick Daily Price Chart over 12 Months

Exhibit 22.3: Example of Candlestick Monthly Price Chart over 30 Years

Exhibit 22.4: Example of Candlestick Weekly Price Chart over 10 Years

Exhibit 22.5: AAPL’s Daily Price Chart with Volume Showing Support and Uptrend

Exhibit 22.6: Daily Price Chart with Momentum Oscillator

Exhibit 22.7: Best Practice (Skills): Blend Technical Analysis with Fundamental Analysis

Exhibit 23.1: Best Practice (Knowledge): Ensure Content Has Value Using the ENTER™ Framework

Exhibit 24.1: Communication Channel Trade-Offs When Presenting Stock Ideas

Exhibit 24.2: Best Practice (Knowledge): Delivery Channel Pros and Cons for Communicating Stock Ideas

Exhibit 25.1: Best Practice (Knowledge): Ensure That the Message Has Value Using the CASCADE™ Framework

Exhibit 25.2: Best Practice (Knowledge): Terms and Phrases Used by Practitioners

Exhibit 26.1: Best Practice (Knowledge): Specific Tips for Presenting to Others

Exhibit 26.2: Best Practice (Skills): Specific Tips for Creating PowerPoint Presentations

Exhibit 26.3: Best Practice (Skills): Specific Tips for Marketing Handouts

Exhibit 26.4: Best Practice (Skills): Specific Tips for Leaving Voicemails

Exhibit 26.5: Best Practice (Skills): Specific Tips for E-mails and Text Messages

Exhibit 26.6: Value of Report Qualities

Exhibit 26.7: Value of Report Components

Exhibit 26.8: Best Practice (Knowledge): Special Considerations for Writing Research Reports

Exhibit 27.1: Best Practice (Skills): Follow Ethical Practices to Make the Right Decisions

Preface

I thoroughly enjoyed my career on Wall Street. I couldn’t have asked for more thoughtful clients, talented team members, or supportive research management. But during those 16 years, I became intrigued by the criticism surrounding the quality of equity research, often coming from within the industry. There was no shortage of intelligent, hard-working individuals. So why wasn’t there an abundance of world-class research? I’m not sure that I solved the entire mystery, but I did reach one major conclusion: There are few, if any, quality control processes. Furthermore, there is minimal professional training provided to equity research analysts.

Think about it: An experienced portfolio manager is relying on internal buy-side and external sell-side analysts to provide accurate, insightful information to make decisions that can impact millions, and possibly billions, of dollars of return over the life of an investment. And yet most of these analysts never received professional training beyond what they picked up on the job and classes they may have taken in college. Instead, our profession relies on the medieval master–apprentice approach, which results in training only as good as the master. Our society doesn’t allow this in the medical, legal, or accounting professions, or even for licensed plumbers or electricians. Those fields require that certain best practices be learned, and that mastery be validated by a certification process. The closest thing we have is the CFA certification, which is highly credible, but not required for the profession. (Only a fraction of equity analysts are CFAs.)

So how bad is it? Let me first say, I’ve met more talented buy-side and sell-side analysts than I can count—individuals who produce impressive alpha-generating research. But unfortunately, this has been the exception more than the rule. As an analyst who worked at four of the largest sell-side firms in the United States, I witnessed too many inexperienced analysts making poorly constructed stock calls, often based on unsubstantiated theses (including me, during the first few years of my career). Worse yet, often in instances where the sell-side analysts produced good research, they couldn’t effectively manage their franchise to get recognized by clients.

I didn’t sense it was substantially better on the buy-side. Based on the 100 to 150 conversations I had with my clients every month, it was clear that there were too many buy-siders struggling in their roles, specifically failing to identify the factors most likely to drive their stocks. Occasionally, when I would get off the phone with a buy-side professional discussing a stock his or her fund owned, I’d wonder how the person could fail to understand some of the more basic elements of the story. To illustrate my point, here are some real-world comments I heard during my career:

• I don’t want to touch that stock because I’m concerned about a labor strike (even though the company was non-union and would benefit from a strike at its unionized competitor).

• We sold the [transportation] stock because oil prices are likely to rise (even though this company’s adjustable fuel surcharge was so lucrative that margins expanded when fuel prices rose).

• I’m recommending this stock because we’re bullish on ethanol (even though ethanol was less than 1 percent of the company’s revenue, and under an ultra-bullish scenario would go to no more than 3 percent of revenue over five years).

If these individuals were investing their own money, I could easily accept their misunderstanding of the company’s fundamentals. But it was other people’s money—people who were entrusting them to fully understand the investment case for a stock, which clearly wasn’t happening. A buy-side analyst, with more than 10 years of experience at a firm managing over $ 100 billion in assets highlighted the impact this has had more recently, when he said, Wall Street is shrinking because a generation of investors are alienated with equities. To help remedy the credibility problems he believes, Anyone who wants to be successful in this business needs to follow best practices. (His thought was an inspiration for the book title.)

In 2006, after having been a sell-side analyst for 14 years, I decided to do my part to help improve the industry’s quality issues by taking on a newly created role to develop a global training program for the one thousand employees in my firm’s equity research department. Based on my experience as an analyst and holding this role, I began to formulate best practices for equity research analysts, which I later refined further through interviews with practitioners from other sell-side and buy-side firms.

There may be seasoned practitioners who consider my recommendation that analysts strive to follow these best practices as too ambitious, remarking, There’s no way an analyst could do all this. I agree; for many practicing analysts, such as those on the buy-side who are asked to closely follow well over 50 stocks with no support (or over 20 on the sell-side), it will be a challenge to implement many of the best practices, for sheer lack of time. These individuals are attempting to put out a high-rise fire with a garden hose. If there is cynicism about implementing best practices, I’d question if it’s coming from the same population that underperforms the market each year. The industry has massive performance issues, and nobody seems to know how to fix them. (According to Standard & Poor’s most recent data, 60 percent of U.S. equity funds underperformed their benchmarks over the past five years, which drops to a still disappointing 56 percent over the past three-and one-year periods.) I have one remedy: Reduce the amount of stocks an analyst covers. I’m not diminishing the need for generalist analysts, but let’s call them what they are: portfolio managers or assistant portfolio managers. The best practices found here will likely help any type of equity analyst, but many are designed for those who look at their stocks from a bottom-up perspective and, most importantly, don’t cover an excessive number of stocks.

If you’re not sure how to prioritize the material that follows, new analysts should first focus on Part 1 because the topics are central to everything an analyst does. Experienced analysts can potentially jump to some of the most pressing challenges they face by focusing on (1) identifying and monitoring critical factors (Chapter 8), (2) forecasting scenarios (Chapter 18) and (3) improving their stock calls (Chapter 20 and 21). Alternatively, first read all of the book’s exhibits labeled Best Practice and then go back to the chapters where you have the greatest interest.

The material attempts to solve problems that are typical for buy-side and sell-side roles, and drills down with more detail when it’s clear a solution for the buy-side role is different than for the sell-side. It’s important to note that all of the best practices were used by one or more of the practitioners interviewed for the book or by my team during my career. I’ve provided the practitioners’ names when referring to their quotes throughout the book, but unfortunately a number are restricted by their firms from being identified for attribution. (Morgan Stanley allowed its analysts to be quoted, which explains why they appear more featured than other firms throughout the book.) Some of the best practices may appear ambitious to implement, but others have done it. Be mindful of the adage, You don’t achieve goals you don’t set.

This book wasn’t written simply to help analysts improve, but also to give them the competitive advantage to move to the top 10 percent of their peers. This isn’t a textbook; the intent is not to repeat concepts already learned in college, but to provide what’s required to get the job done successfully for buy-side and sell-side practitioners. When I set out to create these best practices, the goal was to get as much concentrated material into one place as possible, but space constraints prohibit in-depth discussions in many topics. The goal was to identify the skills and the body of knowledge required for success, but it’s unrealistic to think that everything an analyst will ever need to know will be in one book, especially for complex subjects such as accounting, statistics, valuation, and technical analysis. Hopefully, after reviewing these best practices an analyst will at least know what he or she doesn’t know. From there, the challenge will be to become proficient in those skills or gain greater knowledge. The best-practice exhibits are intended to be stand-alone tools that an analyst can quickly review to help master that task, and thus the content in the exhibits is often found elsewhere in the text. Due to space limitations, supplemental information can be found at AnalystSolutions.com. Furthermore, I encourage you to visit www.AnalystSolutions.com/book to provide your best practices or additional input to make these best practices better. It’s my expectation that this body of knowledge will evolve as more practitioners contribute their best practices.

When I was an analyst, I was a big believer in being transparent to my clients so they could see my potential biases. In this spirit, it’s important to disclose that during the writing of this book I haven’t received compensation from any of the companies or vendors mentioned in this book, other than the use of FactSet’s database to compile data for the book (to whom I’m thankful) and a diminutive dividend from unvested Morgan Stanley stock I don’t yet control (awarded as compensation when I was an employee).

I can’t think of a better job than the role of an equity research analyst. If you do your job well, you’re essentially your own boss, deciding how to spend your time, with almost full control over your career success. There’s frequent interaction with some of the sharpest people you’ll ever meet. No two days are ever the same. And if you like to travel, there’s often no limitation on the number of places you’ll see. Oh, and did I mention the pay isn’t too bad? To anyone who complains about the profession, including those who say it’s no longer fun after Regulation FD and the Spitzer Settlement, I challenge them to find a more rewarding career. Hopefully, the material that follows will help make this career just a bit more rewarding.

Acknowledgments

I’d like to start by thanking those friends and colleagues who spent considerable time helping draft and edit portions of the manuscript, including Lauren Bloom, Chad Bruso, Dorris Dolph, Hunter DuBose, Chris Gowlland, Elmer Huh, Bob Jones, Barbara Lougee, Kurt Moeller, Quentin Ostrowski, Judy Sheehan, Barry Sine, Emma Valentine, and Chris Wright.

I would also like to thank all of the friends and colleagues who helped provide insight for the book as well as those who had a significant influence in shaping my view of the profession and many of the best practices in this book: David Adelman, Ajit Agrawal, Christine Arnold, Reena Bajwa, Jay Bennett, Rich Bilotti, Michael Blumstein, Bob Brizzolara, Celeste Brown, Nathan Brown, Zach Brown, Jeff Burton, Mayree Clark, Doug Cohen, Jim Crandell, James Crawshaw, Christina Dacauaziliqua, Darius Dale, David Decker, Ridham Desai, Christian Drake, Michael Eastwood, Jason Eiswerth, Robert Fagin, Simon Flannery, Casey Flavin, Phil Friedman, Steve Galbraith, Steve Girsky, John Godyn, Rory Green, Bill Greene, Michael Griffiths, Gem Guiang, Ian Gutterman, Phil Hadley, Nick Harness, Trevor Harris, Tony Hatch, John Havens, Shora Haydari, Matt Hedrick, Alison Henry, Marvin Hill, Allison Hirsch, Dickson Ho, Barry Hurewitz, Vlad Jenkins, Drew Jones, Rupert Jones, Hani Kablawi, Jane Kamneva, Jeff Kanter, Ronny Kaplan, Allison Kaptur, Ed Keller, Evan Kurtz, Michelle Leder, David Lee, Chris Leshock, Mark Liinamaa, Steve Lipmann, Dario Lizzano, Adam Longson, Steve Madonna, Mike Manelli, J. P. Mark, Gerson Martinez, Mike Mayhew, Brian McGough, Mary Meeker, Greg Melich, Ron Monaco, Suzanne Morsfield, Jack Mueller, Todd Neel, Peter Nesvold, Matt Nielsen, Matt Ostrower, Robert Ottenstein, Vikram Pandit, John Pastorelli, Howard Penny, Steve Penwell, Juan Luis Perez, Ken Posner, John Quackenbush, Glenn Reicin, Lauren Rich Fine, Alan Richter, Jack Rivkin, Jim Runde, Mike Ryan, Joe Saiz, Eli Salzmann, Menno Sanderse, Alice Schroeder, Carl Schweser, Wes Sconce, Alkesh Shah, Stephanie Shaw, Dennis Shea, Jay Sole, Matthew Spahn, George Staphos, Josh Steiner, Joe Swanson, Naoki Takemoto, Gerry Tavolato, Jim Tierney, Bill Van Tuinen, Jeanette Ventura, Mike Vitek, Steve Volkmann, Jim Voytko, Marcus Walsh, Nelson Walsh, Bill Wappler, Guy Weyns, Greg Whyte, Byron Wien, Joe Wilkinson, Frank Wilner, Will Wrightson, and Dennis Yamada.

I would also like to thank Morgan Ertel, Leah Spiro, and Jennifer Ashkenazy for their help in making this book a reality.

Introduction

No man was ever wise by chance.

—Attributed to Seneca the Younger

Need for Best Practices

There are plenty of obstacles to learning best practices. As I’ve spent time studying the training profession since leaving Wall Street, it’s become clear that there’s one major difference between the learning we do in our profession and the learning we did in college: The what’sin-it-for-me factor is much higher for professionals. Without a clear incentive system, most professionals don’t see the point in continuing education. Further raising the bar for professional learning, many corporate training programs are not learner-centered, but instead built around the needs of management. This is similar to how the computer industry failed to deliver user-centered solutions until Apple came along. I can’t say the material in this book will be as exciting as a new iPhone or iPad app, but it has been assembled with the learner in mind, enabling quick access to the knowledge and skills required for success.

Some analysts may ask, Why do I need to learn how to be an analyst when I can just learn it on the job? Their competitors are glad these analysts have this view, because it increases their odds of failure. This was echoed by the director of research of a large hedge fund who said, We like that there are a bunch of people doing mediocre research, because it gives us more opportunities. Here’s why there is a significant need for best practices within the profession:

• Most on-the-job training for equity analysts follows the master–apprentice model, which has some notable flaws. Most new equity analysts work for senior producers who have little time to train new hires. After all, portfolio managers and senior sell-side analysts get paid to identify mispriced stocks, and when they fail in their primary role, it can lower their compensation (by six or even seven digits). This often distracts from their secondary role as trainer. Their intense focus on getting stock picks right often leads to a sink-or-swim environment for the new hires under their wings.

• Those producers who rightly make the time to train new hires may not have a style of conducting research worth emulating or the patience required to train others. The ugly truth is that the majority of money managers underperform their benchmark, which means there’s a good chance the mentor is passing along poor practices (or lacks the best practices).

Here are some of the more pronounced situations where equity analysts go wrong, which could be avoided by adopting best practices:

• Cover too many stocks or fail to effectively manage inbound information flow, which reduces the likelihood of identifying unique insights required to generate alpha.

• Fail to understand the critical factors likely to drive a stock, which leads to spending too much time on factors that won’t move a stock and too little time on those that will.

• Don’t develop the unique industry contacts and information sources required to make differentiated stock calls.

• Don’t understand how to interview a management team or industry contacts in a manner that extracts unique insights.

• Fail to understand how companies and the media can deceive through numbers, thus missing opportunities to avoid the blowups.

• Generate financial forecasts with no basis other than an inexperienced gut feeling or company management guidance, leading to earnings and cash flow forecasts well above realistic levels.

• Apply premiums or discounts to valuation multiples on an arbitrary basis.

• Communicate stock messages ineffectively, either by being too verbose or failing to identify how the analyst’s work differs from consensus.

• Make poor ethical decisions due to a lack of understanding of how to spot and defuse conflicts of interest.

The Road Map

The best practices that follow are intended to help analysts avoid these mistakes as well as overcome typical challenges more easily. They’ve been divided into the five primary areas of the equity research analyst’s role, as highlighted in Exhibit I.1.

1. Identify and monitor critical factors

2. Create and update financial forecasts

3. Use valuation methods to derive price targets or a range of targets

4. Make stock recommendations

5. Communicate stock ideas

Before an analyst can jump into any of the five areas, it’s important to develop organizational and interpersonal skills, such as time management, setting up an information hub, and influencing others. These topics are covered in Part 1. Once this foundation is established, we discuss the best practices for generating qualitative insights in Part 2. These best practices help analysts identify the critical factors and information sources necessary for better forecasting. Part 3 explores the best practices for generating quantitative insights, such as utilizing statistics, accounting, and Microsoft Excel to create a better set of financial forecast scenarios than consensus. Then, we move on to Part 4 to cover the best practices for valuation and the all-important stock picking. And the job doesn’t end there; analysts need to effectively communicate their message if they are to be rewarded for their efforts. We explore this topic in Part 5. We conclude by highlighting best practices for making critically important ethical decisions in Part 6.

Exhibit I.1 Primary Tasks of an Equity Research Analyst

Just a Few Truisms

In general, I believe each problem should be solved with its own unique tool, and as such, I’m hesitant to offer sweeping advice about how to be a successful analyst. But as I was assembling the book, it occurred to me there were a number of themes that transcended more than one best practice. Here are some beliefs I subscribe to that were reinforced from the research conducted for this book:

• Be skeptical, very skeptical, and even more skeptical. Great analysts rarely accept anything at face value. Douglas Cohen, who has spent 16 years at Morgan Stanley as both a sell-side analyst and a portfolio manager, focused on using the best ideas from equity research put it well when he said, Good analysts always challenge what they’ve been told or given. Over time, if a source of information proves accurate, let it into your circle of trust. If we include the financial press and everything distributed by companies, I’d say at least 75 percent of the information out there for consumption by financial analysts is misleading or omits an important piece of information relevant to the topic. Herein lies the challenge: You need to determine which 25 percent is reliable and then, which portion of that is critical to your investment thesis. Very often, less than 2 percent of the available information will help make an investment decision that creates alpha. And that 2 percent of the information today won’t likely be found in the same place as the 2 percent you’ll need in six months.

• Beyond sheer intelligence, properly prioritizing your time is the single biggest factor that separates the good from the great. We all have the same 24 hours per day to find the 2 percent of information that matters, but some have figured out how to use the time better than the rest.

• It’s tough to beat the market. In doing so, don’t look for shortcuts or quick answers as a substitute for thorough research, because they don’t work—at least not consistently. If they did, capital would be attracted to these easy money strategies until all of the alpha was captured.

• Fear is more powerful than greed, but they are both important to watch. When you see others becoming fearful, look for opportunities. When you see others becoming greedy, look for an exit.

• When it comes to the investment process, simplicity trumps complexity. The more complicated the model, catalyst, thesis, etc., the greater the likelihood something will go wrong.

• Forecasting is not as much about getting the exact EPS or revenue figure correct, but determining that expectations need to be raised or lowered materially (e.g., if your marquee reads, XYZ Likely to Earn $3.00 when consensus is at $2.50, you have a winner, regardless of current valuations).

• For the most part, company management is not good at telling investors:

How well the economy will perform in the future, because their macro crystal ball is rarely better than anyone else’s.

When their company’s revenue growth rate will slow or margins weaken, because management rarely spots the negative inflection points. (They will argue their bullish view with investors and sell-side analysts as they’re driving off the cliff.)

Where the directions of commodities or currencies are headed. (There’s an entire industry of professionals dedicated to this 24/7, who are routinely challenged to get it right.)

• Don’t mistake news for research:

The media tends to hype things; don’t forget that they get paid by advertisers who want to maximize eyeballs, not objectivity. To this end, data can be, and often is, misconstrued to meet the needs of the journalist.

Experts in the press often aren’t; they may simply be the person who had time for an interview.

Hopefully, these truisms can serve as helpful guiding principles, but the challenges most analysts face also require thorough and often very specialized solutions. The material that follows has been developed and organized in an effort to help analysts efficiently reach those solutions by following the best practices of other successful practitioners.

Chapter 1

Do You Have What It Takes to Be a Successful Analyst?

This best practice isn’t intended to tell analysts if they are guaranteed to be a success, but rather to make them more aware of their strengths and areas for development. I’ve recently built an assessment tool for research analysts in conjunction with a consulting firm that specializes in this area. It’s still a bit early to draw sweeping conclusions, but my preliminary findings help show how experienced buy-side and sell-side analysts differ from novices and how the degree of experience for sell-side analysts impacts their perspective of the job. Spoiler alert: Don’t read this section if you intend to take the online assessment (www.AnalystSolutions.com/assessment), as it will undoubtedly bias your responses.

As part of the ongoing assessment development, I survey successful, experienced buy-side and sell-side analysts asking them to respond to questions