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The Keys to Long-Term Success As an Equity Analyst

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James Valentine is a former Morgan Stanley equity analyst, associate research director and author of Best Practices for Equity Research Analysts. He now heads up AnalystSolutions, which provides services to improve the quality of equity research. Valentine will be a featured speaker at the CFA Institute Conference: Security Analysis and the Search for Value, later this month. In the run up to the conference we talked with Valentine about some of the key qualities equity analysts need to cultivate to achieve success over the long term.

You maintain that many analysts spend too much time focused on information that has no bearing on their ability to generate alpha. How then do you suggest they deal with the information overload in the financial marketplace?

From my perspective there are three things analysts need to be successful: intelligence, a reasonable amount of firm-wide resources, and to use their time effectively. The only one of those variables they have control over is how they manage their time. You can’t research every aspect of a company. So how do you best manage your research time? The answer is to focus your research only on those factors most likely to move a stock. This sounds obvious, but I would say 75 percent of the colleagues and clients I worked with over the years analyzed information in a reactive way—reading emails, listening to voicemails and presentations as they came in, rather than be proactive by seeking just the key information they need. When responding to the agenda of others, it’s tough to identify factors outside the consensus view.

So I suggest to analysts that they identify the 2 to 4 factors most likely to move their stock over their typical investment time horizon. It takes work, but if you invest the time upfront all the other information that comes your way that is not critical to those factors can be ignored. Based on our research, top analysts stay very focused on about 2 to 4 factors that will move their stock. I strongly suggest that young analysts do this proactively and that senior analysts add it to their existing workflow. It is a fantastic time-management tool because it filters information.

Can you describe the process?

It is a two-step process. First you identify what moved the stock in the past and then identify the current investment controversies taking place in the present. You might ultimately identify 30 factors, at which point narrow them down to just the critical factors by ranking them on materiality to the stock and probability of occurring. None of this is rocket science; it is just applying a process. It gives you a strategic plan as opposed to letting all the market information wash over you.

If you want to have success as a sell- or buy-side analyst, a big part of it comes down to having a better long-term forecast than the consensus, and the further you go out the more likely you can have a differentiated forecast. It’s a challenge to determine if the market will be right or wrong over the next week or so, but it is much less difficult to determine this for next year, provided you have done good work on your critical factors.

You note that analysts are often tripped up by psychological mistakes. What are some of the most common of these?

Cognitive dissonance is one of the most common of psychological traps. This happens when analysts refute or ignore information that runs counter to their thesis, and seek out information that confirms their thesis. It is a natural process and yet analysts are often unaware it is happening. Once you have an out-of-consensus thesis you need to seek out where you could be wrong. By doing this you will reduce the problems caused by cognitive dissonance.

For example, if you were going to make a stock call based on your view that a company’s negotiations with its unionized workforce was unjustifiably weighing too much on a stock price, you would want to also research where you could be wrong. This could be done by interviewing the union’s leadership, who most likely wants to exert the union’s authority. As a general rule, before you make a call be sure to understand the other side of the trade.

We also recommend analysts keep a record of their recommendations and earnings revisions somewhere in a computer file, such as in an extra tab in their earnings model, so they can go back to review them to see where their biases may be impacting their calls. The human mind has a tendency to revise history which can allow us to keep recommending a stock even when our original thesis is clearly not playing out as planned.

How can an analyst guard against being derailed by questionable ethical practices?

We break ethical dilemmas down into two broad categories. The first is ethical challenges related to misconduct for personal or professional gain. The second is ethical challenges caused by conflicts of interest where a client is relying on an analyst for an objective investment recommendation. One way to test if you are operating in an ethical manner is to ask yourself, "if I were required to explain my actions on television, would I be comfortable following through with my actions?" If the answer is no, you should rethink it. We have three other tests like this to help you decide if your behavior or action is ethical.

We also advise as soon as you have decided to take the ethical, but often more difficult, course of action, do something immediately that puts a flag in the sand to prevent you from taking a less ethical route. Tell your boss or document it by sending an email so you are committed to your decision. Warren Buffet put it well when has said it takes 20 years to build a reputation and five minutes to ruin it. If you want to develop a long-term reputation as a great research analyst you need to maintain strong ethical values.

—Susan Arterian Chang writes on the topics of sustainable finance and investing, and is Director of Content Development for Capital Institute.

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