The 8 principles of a good equity research analyst

By | June 29, 2013

Although every problem should be solved with its own unique tool, here are some principles that transcended the specifics and govern the broad equity research practice:

1. Be sceptical. Very sceptical, and even more sceptical. 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, about 75% 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% is reliable and then, which portion of that is critical to your investment thesis. Very often, less than 2% of the available information will help make an investment decision that creates alpha. And that 2% of the information today won’t likely be found in the same place as the 2% you’ll need in six months.

2. Prioritize. 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.

3. Understand 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 all attracted to these “easy money” strategies until all that alpha was captured.

4. Understand fear and greed. 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.

5. Keep it simple. 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.

6. Understand it’s all about expectations. Forecasting is not as much about gelling 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).

7. Don’t trust management. 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).
  • In which direction commodities or currencies are headed. (There’s an entire industry of professionals dedicated to this 24/7 and even them tend to routinely fail to get it right).

8. 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.

Bear in mind that the challenges most analysts face also require thorough and often very specialized solutions, but hopefully, these can serve as helpful guiding principles.

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