In our current financial market, equity research is a valuable function. The profession has been criticized in recent years.
Toptal Finance Expert Ryan Downie explains how to use research reports more efficiently in this article. He also outlines equity research as a valuable tool for retail and sophisticated investors.
Investors who are sophisticated professionals
You likely have developed your valuation techniques and qualitative investment criteria as an experienced or sophisticated investor. As you will most likely do your due diligence prior to investing, the advice of others may be irrelevant.
Even if you have a wealth of experience to draw on, there are still some important things to keep in mind.
Buy-side professionals can maximize their time by focusing on research that compliments their internal capabilities. Asset management is no exception. Successful businesses rely on delegation. Research from external parties can be helpful:
Regulations prohibit corporate management teams from selectively providing material information to investors. This creates restrictions for large fund managers who need specific information in order to evaluate a stock.
Fund managers can circumvent this by attending events hosted by firms on the sell-side that have relationships with executives from their research subject.
In addition to one-on-one sessions and breakout sessions, corporate management teams and buy-side clients often attend conferences. This gives institutional investors the opportunity to ask specific questions.
In conference calls or filings, the language used to describe corporate strategies such as restructuring, turnarounds, and expansion plans can be vague. One-on-one meetings provide an excellent opportunity to dig deeper into these plans in order to confirm their feasibility.
Management teams that are able to act quickly can verify the validity and plausibility without breaking any regulations. It should be obvious if a plan is poorly conceived.
The sell-side firms offer their institutional clients the chance to express the topics they would like to be addressed by the company management during quarterly earnings reports and conference calls.
Deeper Insight
A sell-side analyst’s role as a public figure and his relationship with corporate management also allows him to probe deeper insights strategically. Good equity research shows that the analyst is focused on extracting information that is most relevant for institutional clients. It is often necessary to ask intelligent and insightful questions in order for management teams to reach the optimal balance when it comes to financial outlook disclosure.
Analysts and investors on the buy side have to wade through a large volume of research from the sell side, particularly during earnings season. Therefore, brief analytical pieces are more valuable than reports, which repeat information found in press releases or financial filings. The value of these revelations is evident if they echo the concerns or interests of investors.
Outsourcing Research Activities That Are Low-ROI or Tedious
Some smaller buy-side shops lack the resources necessary to track entire sectors and identify important trends. By consuming research reports, these asset managers can widen their net. Sell-side analysts are usually specialists in one industry. They closely monitor the performance of their competitors and external influences that may have a sector-wide impact. This gives context and nuance to a selection of candidates and positions that would otherwise be overlooked.
Shareholders can use research reports to detect subtle red flags that might be missed if they read through all the financial information. Changes in reporting, governance concerns, off-balance-sheet items, etc., are all red flags.
The buy-side investor will certainly dig into these topics on their own. However, it is useful to have multiple perspectives on portfolio components that could number in the hundreds. Building a historical financial model can also be time-consuming and not provide the best ROI to shops with limited resources. Investors can add value by focusing on forecasting and a better analysis of financial data. Sell-side analysts create competent models.
Idea Generating
Identification of investment opportunities is a tedious activity, as screening an entire sector or market can be overwhelming to a small team in some buy-side firms. Idea generation is now a key component of the services offered by some sell-side firms. This is particularly true for small and medium-cap stocks that may be unfamiliar or unknown to institutional investors.
Most buy-side teams cannot cover the entire universe of investable assets.
Research teams can fill a gap by analyzing newcomers or smaller stocks that are not widely known. They can then bring these to the attention and scrutiny of institutional investors.
Context
For sophisticated investors, reports can be a great way to gain a meta-perspective. Stock prices are heavily affected by short-term influences, so investors will learn more about price changes by monitoring research as a group.
Researching the market allows investors to compare the current situation with historical events and take a “temperature” of the industry. The market tends to repeat itself, in part because the industry tends to shake when there are crashes and attract new professionals during bull markets.
A detached perspective helps to shed light on cyclical patterns, making it easy to identify warning signals that may be missed by those who are less familiar. This, in turn, leads to the generation of new investment opportunities.
Investors should avoid consuming research that confirms their bias. This is a powerful force that has contributed to past booms and crashes in the market.
Retail Investors
Retail investors are less technical than institutional investors and, therefore, have a greater need for equity research.
Research can help fill in some of the gaps on some basic levels. It can provide guidance for investors, frame an investment narrative, identify relevant issues, or make buy/sell recommendations. Research can help investors fill in some of the gaps on a basic level by providing modeling guidance, framing a narrative for an investment, identifying issues, or making buy/sell suggestions.
Retail investors looking to get the most out of their research can start with these great resources. Asset managers have access to a vast amount of information that retail investors may not be able to consume.
What are the risks of equity research?
In spite of the above, it is clear that trading decisions should not be made solely on equity reports. In order to properly assess the risks of equity research, it is important to consider the motivations and incentives of the research producers.
Many factors, including regulations, professionalism, peer and client scrutiny, and the oversight of peers and clients, influence research integrity. Consumers of research should consider the business model of producers. Below, I’ve highlighted five important issues.
Due to the need for trading volume, equity research can be exaggerated.
Banks and brokers usually produce reports to generate revenue. Investment banks often add sell-side equity to their business, which is a lucrative addition.
In order to highlight these opportunities, the research is often focused on stock trading. The study reports that only forecast “steady” performances would lead to less trading. Research analysts are, therefore, motivated to make predictions about a change in routine, whether up or down.
Many academic papers and industry white papers have been written to estimate the magnitude of analyst errors. The results have changed over time and between different studies. All consistently conclude that analyst estimates do not tend to be accurate.
Andrew Stotz indicates that the average error in EPS (earnings-per-share) estimates from 2003 to 2015 is 25 percent, with a minimum of 10 percent per year and a maximum of 50 percent.
