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The Proper Care and Feeding of Great Analysts
What makes great analysts so great? And can others learn their secrets?
BY JAMES VALENTINE, CFA
o great analysts possess specific skills and knowledge? I set out to answer this question by interviewing dozens of practitioners, and from that work, it became clear that they have mastered six skills: (1) Properly identify and monitor the critical factors most likely to influence a stock. (2) Create or obtain financial forecasts more accurate than consensus. (3) Leverage financial forecasts and valuation methods to derive superior price targets. (4) Consistently understand where consensus is wrong and the catalyst most likely to move a stock. (5) Clearly and succinctly communicate insightful stock recommendations. (6) Master interpersonal and organizational skills. For sell-side analysts, a seventh skill is also required: (7) Successfully manage their franchise as an ongoing commercial enterprise.
Identifying and Monitoring Critical Factors
sell-side analysts who have more accurate earnings estimates also tend to have more accurate stock picks.1 Regardless of your method, the key is to ensure that your forecast is more accurate than consensus. Self-assessment of this ability is often easy to do. Buy-side analysts should check their performance using in-house metrics, and sell-side analysts should regularly reference objective third-party services (such as StarMine, which tracks analysts’ earnings accuracy). If data isn’t available, analysts should keep records of how well their estimates perform relative to consensus by simply recording both numbers in a worksheet each time a revision is made to the model. Remember the old management adage — you can’t manage what you don’t measure.
Superior Price Targets
Do you have a list (written down or in your head) of critical factors that you watch for each stock in your assigned universe? If so, how many factors are on that list for a typical stock—5, 10, or even 20? Great analysts identify critical factors and then narrow down their list to 2–4 per stock. This trait allows them to do two important things: (1) dig more deeply than their competition on a few key factors so as to develop a better view than consensus, (2) and avoid wasting countless hours on all of the noise that surrounds factors not likely to move a stock. No single irrefutable method exists for identifying a factor as “critical,” but one easy test is to ask whether it’s likely to move the annual consensus forecasts by more than 5 percent. When the answer is categorically “no,” then it’s probably not critical. When the answer is not clear, more research needs to be done to put it into a critical or noncritical column. As a self-assessment check, ask whether you routinely identify and monitor 2–4 critical factors per stock. If so, do you spend the majority of your research time on these factors, especially those for your high-conviction stocks?
More Accurate Forecasts
Just because you’ve mastered forecasting earnings or cash flows doesn’t guarantee alpha generation. Great analysts possess the additional ingredient of applying the appropriate valuation multiple to their forecast. When making buy recommendations, the rookie mistake is to simply apply a favorable multiple to an optimistic forecast, which often ends in disappointment when such a level isn’t warranted for the current portion of the economic cycle or company’s life cycle. Great analysts take time to understand why their stocks command current valuation multiples (relative or absolute) and why they have fluctuated in the past. For stocks that don’t have a history or are forging new growth rates, analysts understand the level the market pays for comparable companies, sometimes requiring in-depth research of unrelated companies or sectors. Analysts can assess their ability in this area by asking whether they know the relative and absolute peak, trough, and average valuation multiples for their stocks (or those with comparable growth rates) going back at least three economic cycles.
Assess Consensus and Have a Catalyst
Do you build, borrow, or buy your financial forecasts? Sell-side and many buy-side analysts build them from the ground up with complex models, yet some buy-side analysts simply tweak the consensus. Studies have shown that
The key to generating alpha is having a more accurate view about a future stock price than the market. This can be done on a consistent basis only if the analyst has an edge over the consensus thinking (while staying within ethical and legal boundaries). Analysts can determine whether their call has an edge by using what I call the FaVeS framework. Specifically, their call needs to be superior to consensus in at least one of these areas: (1) Forecast: financial forecast superior to the market’s. (2) Valuation:
1 Roger Loh and G. Mujtaba Mian, “Do Accurate Earnings Forecasts Facilitate Superior Investment Recommendations?,” Journal of Financial Economics (2006).
MAGAZINE / JAN–FEB 2011
When compared with novices. it’s probably of no value. At AnalystSolutions. it should only be made when there’s also an identifiable catalyst that’s likely to change the consensus view during the investment time horizon. Department of Labor has an exhaustive list of skills describing a financial analyst. you’re probably spending too much time playing defense (or you’re still new to the job and learning the basics of your companies). (5) adaptability. Don’t assume this applies only to sell-side analysts. If the answer is less than 25 percent of your time. (3) awareness of others’ needs. We all have the same 24 hours a day to generate alpha. You don’t need to have all three elements. (2) communication skills (both speaking and writing). too many calls are made that lack any of these elements. they approach their job on the offensive rather than playing defense. An equity research analyst should strive to master eight key influencing skills: (1) self-awareness. The list is respectable. Take the documents you used for your prior 5–10 stock calls (reports. Unfortunately. we’ve developed a self-assessment tool to help analysts understand how their views differ from senior analysts. your probability of success increases. This means they only take meetings. • are more comfortable articulating the strategies of all the companies they follow and how they differ from their competitors. but unfortunately. Self-assessment of this skill is relatively easy. The best analysts know how to use this time better than their competitors. • when their price target materially differs from the current price. Communicate Your Insight provide insights — always in an ethical manner — as well as influencing others to act on stock recommendations. • fully understand the peak and trough valuation levels for their companies going back at least 10 years. and (8) credibility. This sounds harsh. (3) Sentiment: forecast of investor sentiment superior to the market’s. All good stock communications should have these elements: (1) Expectational: provides insights about the future. because. CFA MAGAZINE / JAN–FEB 2011 11 . another important consideration is the need to get their ideas into the portfolio. e-mails. Self-assess yourself by asking how many hours per week you are proactively researching the few critical factors you think consensus is wrong about. I’ve developed the ENTER framework. but if your call has none. (4) Examinable: provides decision makers (portfolio managers or clients) with the information used to make conclusions. not only a hunch. It’s still a bit early to draw sweeping conclusions. but based on those who have taken the assessment to this point. too many analysts try to scan everything as part of a coveryourself strategy. calls. or scripts for presentations) and see whether they possess these elements. (6) network building. • when recommending a stock. Interpersonal and Organizational Skills The U. except that influencing skills are ranked too low (social perceptiveness is ranked 15th. go back to your previous 5–10 stock calls and ask which of the FaVeS framework elements each call possessed and whether the catalyst(s) was (were) identified in advance (try to use documents created at the time of the call to avoid letting your mind revise history). (5) Revealing: exposes risks and acknowledges a conviction level. if you know the requirements of the job and strive to master each of these areas. As with any profession. preliminary findings help show how experienced buy-side and sell-side analysts differ from novices. The more you can include. (4) listening skills. especially catalysts likely to move the market toward the analyst’s out-of-consensus view. in addition to buy-side analysts being evaluated on their stock-picking ability. place more focus on the factors that distinguish their view from consensus. It’s not unusual for a rookie analyst to seek recognition for simply parroting management’s guidance as the key tenets of his or her stock call even though the call doesn’t have any of the above elements to make it superior to the market’s view. but great analysts know where they excel and where they need help. which is a waste of effort for the person making the call and those who are asked to make the trade. Specifically. • are more realistic in appreciating that even the best stock pickers don’t have 100 percent of the information necessary to make a stock call.S. (2) Novel: answers the question “What’s new or unique that’s not already known by the broader market?” (3) Thorough: ensures that the view is backed by sound research. the more value you’ll add to the consumer of the message. Know Your Strengths and Blind Spots Unless you own your own firm. Great analysts are those who can influence others.valuation methodology or valuation multiple superior to the market’s. To help analysts assess whether the content of their message has value. but this approach doesn’t provide them with the time to find ideas that can separate them from the pack. you’ll need to communicate your ideas to be recognized — and eventually rewarded —for your efforts. Even if a call has one of these elements. and read e-mails or reports from individuals who add value in assessing the 2–4 critical factors that drive their stocks. they know where their assumptions differ from the market’s view. (7) confidence. and persuasion came in at 17th). ranked in order of importance from highest to lowest. To evaluate this area. senior equity research analysts • thoroughly understand inputs to their company’s production or creation of their service and the primary markets to which the company sells. This includes influencing information sources to help Few analysts have complete mastery of the six skills mentioned at the beginning of this article.
THE GOODMAN INSTITUTE ADVANCE YOUR CAREER TODAY. they gain more job satisfaction from speaking with clients. analyzing stocks is mostly a relative game. it’s often being sold by someone who thinks you’re wrong. Although there may be investment committee meetings.” If you take away only a single concept from this article it should be this one: Generating alpha is all about determining where consensus is wrong — a point that often gets overlooked by less experienced analysts.For both buy-side and sell-side analysts. years.CONCORDIA. EARN YOUR DESIGNATIONS WHILE KEEPING YOUR JOB! APPLY NOW! JOHNMOLSON. Second. After all. the more they disagree with the following statements: (1) “I build only the bare essential financial model necessary to uncover anomalies and trends. CFA. so does agreement with the following statement: “When recommending a stock I like. set time aside to identify which of the six primary skills are your greatest strengths and which are in need of improvement. When you’re recommending a stock you like. This picture is fairly consistent with my observations of successful analysts. Rather. they tend to be headstrong. which they do by understanding their companies as well as how current valuation differs from the past. TEACHES YOU WHAT YOU NEED TO KNOW IN ORDER TO PASS ALL THREE LEVELS OF THE CFA® PROGRAM. Conclusion We were all rookies at one time. In terms of personality. but on further consideration. 1 exceptional program. 2 designations. OFFERED IN BOTH TORONTO AND MONTREAL FOR THE PAST 10 YEARS.. as their experience increases. has 16 years experience as an equity research analyst and is founder of AnalystSolutions as well as the author of Best Practices for Equity Research Analysts. The key is to be armed with the skills and knowledge to ensure you’ve arrived at the more accurate conclusion. First.” While additional insights emerge as more analysts take the AnalystSolutions assessment. I’m not saying analysts must be introverted to be great. they work and think independently to generate alpha.g. the initial mosaic shows successful. Among the sell-side analyst population. as experience increases. OUR MBA PROGRAM. I was initially surprised by the solitary qualities that emerged. I focus primarily on the factors where my view is distinctly different from consensus. most firms don’t have a team of telecom analysts). this job isn’t a team sport.” (3) “I’m exceptional at finding common ground in times of conflict. let’s face the fact that most of the work typically conducted by analysts is independent of colleagues (e. two things become clear. James Valentine. the more experienced they are. experienced analysts as determined to identify points where they differ from consensus.CA/GIIM CFA® AND CHARTERED FINANCIAL ANALYST® ARE REGISTERED TRADEMARKS OWNED BY CFA INSTITUTE 12 CFA MAGAZINE / JAN–FEB 2011 . and easily roused. But how do we know we are becoming or have become the best analyst we can be? If you’re looking for a way to gain an edge (or more of an edge). independent.” (2) “I have a generally calm disposition.