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11/10/2011

Rethinking the Role of an Analyst


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It is common to question the worth of Wall Street analysts. Whether they love a stock that drops like a rock or are late to the party for one that soars, there are plenty of naysayers. Conversely, many publications analyze recommendations and pronounce certain analysts the best of breed, often using questionable methodologies to do so.

In addition, a huge volume of academic research has focused on the work of analysts, narrowly defining it as crafting earnings estimates and making stock recommendations. All of that is in contrast to surveys of institutional money managers, which consistently show that they place little value on sell-side recommendations versus other factors.

The reality is that far too much attention is paid to an exercise in futility that doesn't really match up to the needs of investors; while stock ratings are fodder for reporting and analysis, they can conceal rather than reveal what an analyst truly brings to the table. But a larger issue is that most analysts are set up to fail.

Think of what we ask analysts to do. (I speak here of fundamental equity analysts, both sell-side ones, who pitch their ideas to institutions and individuals; and buy-side ones, who do the same within their own firms.) While the job can be made to sound simple— to inform and aid decision makers in their choices—it involves quite an array of skills and duties.

THE ROLES OF A SUCCESSFUL ANALYST

To be successful, you need to be a business analyst who evaluates anything and everything. The list of most important considerations varies by industry and company, but think of the pieces: operations, sales, marketing, finance, etc. Any of them can cause problems or improvements within a firm; how well do you understand the internal dynamics of each?

Often you are called on to be a technical expert. Especially in areas like computing or biotech, you can be consumed by the details of the products. At the margin, this can suddenly become a large part of your job in response to key developments.

In addition, you must be an industry expert. Not just in knowing the players and the news (and keeping up with the trade press, attending industry events, etc.), but in understanding the competitive dynamics of the industry and interrelated industries. Plus, you cannot ignore the governmental and regulatory realities and risks.

You must be an astute judge of management talent. In addition to being able to read senior managers well, you need to toe the line to make sure that you are close enough to make good judgments about the capabilities of the management team, but not too close to be taken in by the story they are trying to sell. Assessing the governance structure for danger signs is part of the job too.


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You need to dig into the numbers, serving as a de facto auditor of financial reports. Many industries have specific accounting issues, there are new rules all the time, and shenanigans are not usually discovered with just a cursory review.

With all of this information in hand, you then put on the hat of a forecaster, keeping in mind all of the analytical and behavioral traps that come with it. At some point, you pull it all together to try to figure out what a stock is worth, playing your roles of modeler and valuation expert. No matter how laughingly simple or maddeningly complex your approach, you have to have some way to assess value, and it is usually more art than science.

You might spend some time understanding the particular supply and demand dynamics of the stock itself, although that is something that many fundamental analysts never attempt to do.

Once you have all of that information processing done, it is time to shift gears. Yes, you need a set of conclusions. If you are a sell-side analyst, you probably have to slap a simple rating on all of it and a target price too, for what that's worth. A buy-side analyst may get to paint a richer picture of the possibilities, perhaps even being able to map a range of outcomes as a risk manager might.

Then comes the hard part for many—it is time to be a marketer of your ideas. If you need to put them in readable form, you must be a writer (by the looks of most research reports, not the easiest thing), otherwise a salesperson, going office to office, or speaking to a group, or commenting on a squawk box, or even on television.

I have seen estimates that well over half of a sell-side analyst's time is taken up with marketing duties. Promoting your ideas takes time for analysts at asset management firms too, although nowhere near as much. Many fine buy-side analysts fail because they are not good at communicating their ideas effectively, not because the ideas have no merit.

NOW WHAT?

After all of that, I ask: What are the chances that you are going to be good at this broad spectrum of responsibilities? For 1 stock? For 20 or 40? Sure, you may have an assistant or even a team to bear some of the burden, but are they organized in a way that recognizes and emphasizes the key pieces of the research puzzle that you face?

It is time for a radical rethinking of the analyst role as now practiced. In most investment organizations, we have made it too easy to say, "Those darn analysts…" without stopping to realize that we have constructed a job that is unwieldy and unlikely to engender success. Let's go back to the drawing board.

–Tom Brakke, CFA, provides consulting to investment organizations on decision making and the communication of ideas. This posting is a modified version of one that appeared on his blog, the research puzzle.

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