Friday, January 21, 2011

Valentine, Best Practices for Equity Research Analysts

James J. Valentine’s Best Practices for Equity Research Analysts: Essentials for Buy-Side and Sell-Side Analysts (McGraw-Hill, 2011) is a how-to manual. If, that is, you have what it takes or can develop what it takes to be a successful analyst—and that includes a rather antisocial (a bit more than contrarian) personality.

The book is divided into six parts that range over such topics as organization, generating qualitative and quantitative insights, mastering stock-picking skills, communication, and making ethical decisions. It is eminently practical in tone. For instance, Valentine offers time management suggestions, tips for leaving voicemails, and instructions for creating the best Excel spreadsheets for financial analysis.

I have no doubt that beginning analysts could avoid innumerable stumbles and that more experienced analysts could hone their craft by reading this book. But since I don’t inhabit that world I have opted instead to share two of Valentine’s insights that all investors can profit from. First, modeling inputs unique to value and growth companies; second, one aid in forecasting changes in market sentiment.

In developing company financial models, the analyst of a value (or cyclical) company will be interested in the following kinds of items: factors that have helped forecast cycle inflection points of the past, capacity additions relative to demand, post-retirement benefits, and off-balance-sheet liabilities. By contrast, the analyst of a growth company will want to identify the ultimate size of the market, sources of funding necessary for the company to grow, and dilution from stock options. (p. 239)

Valentine claims that “The key to generating alpha is having a more accurate view about a future stock price than the market. This can only be done on a consistent basis if the analyst has an edge over the market in one of the three areas that compose our FaVeS framework,” financial forecast, valuation, or sentiment. “Sentiment, void of any fundamental changes, is often the only thing that moves a stock or market in the short-term.” (p. 274)

Unfortunately, correctly forecasting a shift in market sentiment is the most difficult of the three. Valentine makes clear that “the skill to be mastered here isn’t understanding how investor sentiment changes after consensus earnings or cash flow forecasts change, but beforehand.” (p. 281) There are some factors that analysts typically monitor for potential sentiment shifts, such as short interest, insider buying and selling, and the market’s relative appetite for risk (reflected in treasury yields, the VIX, the size of the deal calendar, and the recent stock performance of weak vs. stable companies, emerging markets vs. domestic markets, and small cap vs. large cap).

Valentine claims that “one of the most basic elements for understanding investor sentiment is to know which types of investors” own the stock in question. “For example, if a value fund is buying a stock because it believes the company will be recognized for successfully moving into attractive growth markets, growth investors will need to bid the stock up to a point where the value manager has an attractive exit point. While not every stock fits cleanly into an investment style box, it’s often important to know the investment philosophy of the current owner in an effort to: (1) identify the potential owner who will eventually bid the stock higher, or (2) consider which style is the buyer of last resort should the company stumble. Companies that successfully move from value to momentum can see their stocks easily rise 30 to 100 percent, but should that momentum slow, there’s often nobody to catch the falling knife until it becomes attractive to value investors again.” (p. 282)

Savvy investors and traders who are long a stock should always ask themselves who else owns it, who is likely to buy more, when the appetite for buying is likely to wane, and how difficult it will be to bail as the longs head for the exit.

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