Jun 12, 2008

sell-side analysts

You now who I’m talking about. Those guys on CNBC touting some stock or getting quoted in the Wall Street Journal about this that or the other about some company. Such as,

It appears that especially in the first part of the fourth quarter, Check Point experienced a sharp rebound in its business, wrote analyst Elan Zivotofsky of Goldman Sachs. He estimates that the company showed a strong positive trend early in the fourth quarter, and that this trend was sustained throughout the quarter, although in a more moderated form.

I’m glad I’m not a sell-side analyst. I think it’s an awfully tough gig. There isn’t a more derided profession among the blogs or journals I read. They are generally viewed as clueless, their ratings useless, and their estimates garbage. Most of this I would agree with. However I find them incredibly useful.

Next time you see something stupid written or stated by an analyst keep this in mind: You aren’t paying them anything for their advice.

This is an important point. Why on earth would you expect to get anything useful out of someone where you aren’t giving them something in return?

I on the other hand do give them something. Money. Lots of it. And I do that because they help me do my job better. Let me explain how the whole sell-side industry works.

A sell-side analyst typically covers a set of stocks within some sector. For example they might be an Internet analyst or a oil refining analyst. They then do research on these companies, talk to management, create some financial models, forecast some earnings per share numbers, slap a rating on the stock (buy, sell, hold), gain insights on the status of the company, formulate opinions on the effects of market news on that company, and write all that up in ongoing reports. That report is usually what is commented on in stories.

When you hear that “the street estimates” or “consensus earnings numbers” for a stock are so and so, this is just an average of all the sell-side estimates.

In general the estimates, ratings, and reports are largely useless. What is presented to the public is throwaway stuff. In some ways I don’t understand why they do it at all. Nevertheless let’s continue.

So what do they do that is useful? A number of things

  1. Conferences. Sell-side firms will line up a ton of companies and have them present at a conference. This gives someone like me a very effective way to see companies present and also meet the senior management. I can meet 8 companies in a day this way.
  2. Access to management. Beyond meeting companies at conferences they are also useful for getting you a meeting with management. This isn’t always a problem. Usually I can call them directly and get a meeting. But not always. If not they usually come through for me.
  3. Act as sector educators. If you are new to a field, the analyst will come to your office and sit down for an hour or two and walk you through how an industry works, who the players are, give some perspective on the history of the industry and so on. Invaluable.
  4. Data they don’t write about. A sell-side analyst typically has to keep a decent relationship with management or they will be less forthright with that analyst. Also their investment banking wing might be doing investment banking work with that company. A conflict of interest to be sure but a reality in the market place right now. So what they write in reports is rarely the whole story. A call to an analyst usually leads to some additional information or more color on an event that is happening. Why did a senior executive leave for example. Usually they know. A ‘neutral’ rating might really be a ‘sell’ in their mind. Henry Blodget got busted after the Internet bubble popped for writing one thing in his reports and writing something completely different in his emails to colleagues and clients.
  5. Models. No one really uses a sell-side model as it stands. But it represents a great way to start building one. They’ve kept track of all the historical data and metrics and you can use this to quickly build a model of your own.
  6. Bus tours. These are the best. You head out to some are like Silicon Valley and they tour you around different companies. This is better than meeting management, which you do on the tour, because you also get to see the other employees and the work environment. It gives you a better sense of how the business works and the character of the company.

So how do sell-side analysts get paid. This is an interesting and I’m sure archaic way of doing business. Analysts get paid with soft dollars. As opposed to hard dollars where you write a check, soft dollars are allocated during a ‘voting’ process.

Twice a year we are asked to allocate 100 votes across the brokers we use for research help. They tally up the votes and then allocate trading to those brokers in proportion to the votes collected. If Goldman gets 4% of the votes it gets 4% of the trading we do. Goldman then makes money off those trades and this is how the sell side analysts are paid. There has begun a slow movement to kill soft dollar payments. In other words there is a movement to disaggregate the trading and the research. In the future we may very well send trading to the low cost provider or the best executor and write a check to the analysts. That doesn’t happen now but I think it will in the future.

So just keep that in mind next time you hear one of these guys spouting off. What they are telling you is useless. But then again, sell side analysts, to paraphrase the words of Chris Rock, aren’t there for you.

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