The Conflict between Equity Research and Value Investing by SG Value Investor, The Value Edge
I like the process of investing (and of course, the outcome); if someone had asked me two years ago, “What do you want to work as?” I would have said equity research, because it seemed to be congruous to investing then. Unfortunately, for reasons that I will explain, I no longer believe that to be true.
An equity research analyst’s job is to predict the most probable outcome in terms of financial performance for a specific company. I mean, no firm would pay an analyst to simply assume 0% growth projection for the sake of conservatism. In a nutshell, research analysts value firms based on the most probable outcome of events, the mind-set of a value investor, as I would like to think, cannot be more different. An ideal investment is one which is still undervalued even if the improbable happens and financial performance isn’t as good as expected.
System Incentives exacerbates biasedness
It does not pay to be in consensus; an analyst issuing a report which says the same thing as the other brokerage firms will not stand out. Similarly, it would be pointless to initiate coverage on a stock only to rate it HOLD. There is an inherent incentive to be sensational, to be always looking for that STRONG BUY. You might say that an investor experiences the same incentives especially in trying to maximize returns. To that, I would argue that an investor simply as much more flexibility in walking away from any research that he makes on a company because he essentially has the buffet of the entire investment universe. Contrast this with that of a research analyst, most cover only specific industries, if you are in a large bank, there will probably be restrictive market capitalisation requirements; there is only so many times you can walk away before you need to come up with a BUY rating. Such a system seems to encourage biasedness.
It is quite possible to justify something as both a positive or negative development and this, in a biased mind can be deadly. Here are some statements (each from different reports) which I picked out:
Our DCF-based SGD4.50 TP implies 30.9x FY15F P/E. We believe a premium to its Indonesian peers (22.2x) is justifiable, given its excellent management track record and purer exposure.
We believe India requires significant investment in new diesel engines for road construction, mine restarts, oil rigs, commercial vehicles, rail engines, defense ships/vehicles, water pumps, etc.
Keppel has won c.SGD3.7bn of contracts YTD, appearing somewhat behind schedule vis-à-vis our SGD6bn FY14 order win forecast. Yet, we note that such wins tend to be lumpy and it could still pull a rabbit out of the hat at the last minute.
While biasedness can be perceived as the ‘art’ aspect of investing, my point is that for every statistic or logic substantiating a claim, it is highly likely that there exists a contradicting argument which is often uncited. Because of that, you can never be sure if it is disregarded as an insignificant factor, or that it was never even considered in the first place. Rationality does not imply invest-ibility.
A research analyst sells investment advice, but I would bet that a handful have never ever picked up an investment book. There is a distinction between academic finance versus investing, and fresh analysts are evaluated and hired based largely on their knowledge of finance. No interviewer ever asks “What books on investments have you read?” and who can blame them – when you have had years of experience, you don’t need experience in a fresh hire, all you need is someone capable enough of doing the grunt work. Naturally, the people who get hired are the ones who excel in academic finance, and this is manifested at times in reports through the usage of academically sexy, but arguably insignificant in practice, concepts like regression, correlation coefficient or the many highly optimistic DCF models. A large difference between academic finance and practical investing boils down to mentality. In that regard, I think an investor is more likely to adopt a mentality of a business owner while an analyst adopts a mentality of an academic.
There was a time when I was responsible for writing research reports for my club in school. Initially, I only sold BUY ratings for stocks which I really owned in my personal portfolio. As time went on, I ran out of stocks to cover and I simply found any stock that I was capable of rationalising a BUY story, knowing fully that I would never invest in it personally. I’m not saying that I am the next Jordan Belfort, but rather, that I was able to discern rationality from invest-ibility. My fear is that analysts who have never been exposed to the philosophies of investing will not be aware of such a difference. In turn, this is largely engendered by a system that evaluates academic performance and places no value on investment acumen in recruiting research analysts. Sadly, this is perfectly understandable as well.
I think there are several questions to contemplate here for those who are keen on investing as a career, such as myself. Is a good analyst a good investor, or vice versa? Why? If it is not, do I want to be a good analyst or good investor?