‘You don't build a track record in a year'

James Valentine is the author of “Best Practices for Equity Research Analysts” and the founder of AnalystSolutions, a training firm. A former Wall Street star analyst, Mr Valentine was also responsible for training at Morgan Stanley. His book provides training tools to help equity analysts do better at their job. We caught up with Mr Valentine during his book promotion tour in India.

What are the big mistakes/major challenges faced by analysts?

One of the biggest mistakes many analysts make is poor time management. They tend to spread themselves thin rather than using relevant, focussed information for their research.

The second mistake is not developingproprietary sources of information. I think too often analysts depend on financial filings and conference calls for their research. If you want to have an out-of-consensus stock call, you need to have information sources that are out-of-consensus. You need to have something that nobody else has.

The third big mistake or challenge is that many analysts don't have a differentiated, high-conviction call. To have a really differentiated stock call, it has to have one of three elements – a unique financial forecast, a unique valuation, or a unique view towards the sentiment of the market on that stock. And the last big challenge is getting the message heard. Analysts need to develop communication skills which include influencing skills. First you have to have good content. And then you have to deliver the message properly. If you do that, then it's more likely that the client (if you are on the sell side) or the portfolio manager (if you are on the buy side) would adopt your idea.

Some critics say that forecasts rarely work. What is your view ?

I think forecasts rarely work when the analyst has not done a good job. If you simply ask the company for an answer or look at the history and just extrapolate it in to the future, there is going to be a problem. And those are probably the two most common types of forecasts that analysts build.

To do a good forecast, you need to have really good insights. You need to have something that nobody else has. You have to develop your own proprietary sources of content.

How do you do that?

One of the fastest ways is to immerse yourself into the industry, rather than immersing yourself into the companies. Read trade journals and trade blogs. Contact journalists or people quoted in an article or in a blog. Get involved in industry associations actively. Attend industry conferences to the extent possible. Use expert networks if your firm allows you to.

How should an analyst deal with uncertain global macro-economic variables?

I tell analysts not to try to forecast macro-events with accuracy because this is not something they are good at. If they are really good at forecasting global economy or trade, then they should be a strategist or an economist.

So, I tell analysts to take the consensus view on some of these macro-things and then drill down to really try to figure out where they can be different. Analysts need to have a supply and demand forecast for their sector. Also, they need to have a framework of spreadsheet where they can think through various inputs which could alter these demand-supply dynamics.

Sometimes, analysts risk obtaining insider information. How should they deal with this?

This question comes up a lot in my tour of Asia, maybe because of the recent insider trading case of Raj Rajaratnam. From my perspective, it's fairly black and white. An analyst seeking information is trying to build a mosaic of the future to build a forecast. What Raj Rajaratnam was doing was not building a mosaic but trying to take one big photograph. So, there was no question in the jury's mind that he was not doing research.

What I recommend analysts do is first and foremost develop proprietary sources of information. Then, there is a very low probability you'll get inside information. Your proprietary sources are going to be people from the industry, competitors, industry associations or customers of the company. Most of these people are not going to be in possession of material non-public information that the company management has.

How do you gauge analysts in irrational market cycles?

You don't build a track record in one year. When the sub-prime crisis happened, everything went down. If the economy collapses, your stock calls may not play out like they way you thought. You can't do anything about it. But if you've got a track record of five or six years as an analyst, that could still offset it. And by the way, everyone has a bad run that year. So, it's relative. If you are good, you should still be doing better than your peers in the long run.

Has stock picking become more difficult?

It does get harder to pick stocks with more information available. We went through a few phases. In the 1960's, 70s and even in the 80s, simply obtaining the information meant that you could probably pick stocks better than other people. This is because the professional money management hadn't really formed until the 70s and 80s. Then in the 1990s and 2000s, with much more information flow, it came down to the ability to interpret information. Over the last few years, with many quant-shops back-testing data and trying to infer effects of information flow on sectors and stocks, it is getting more difficult to pick stocks.

On the other hand, many investors who got burned in 2008 have decided to take their money out of active management and put it into passive management. The explosive growth of ETFs shows you this. So you could argue that if anything there is more of an opportunity now, with all this kind of dumb money. It's not a dumb product, but it's kind of dumb money out there is not really thinking about how it gets invested. This can be exploited by people who are actually into research.

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