James J. Valentine. - Best practices for equity research analysts: essentials for buy-side and sell-side analysts /

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

I thoroughly enjoyed my career on Wall Street. I couldnt 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 wasnt there an abundance of world-class research? Im 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 masterapprentice approach, which results in training only as good as the master. Our society doesnt 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, Ive met more talented buy-side and sell-side analysts than I can countindividuals 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 couldnt effectively manage their franchise to get recognized by clients.

I didnt 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, Id 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 dont want to touch that stock because Im 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 companys adjustable fuel surcharge was so lucrative that margins expanded when fuel prices rose).
• Im recommending this stock because were bullish on ethanol (even though ethanol was less than 1 percent of the companys 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 companys fundamentals. But it was