Wall Street Research: Much Ado About NothingRoberto Sanchez
One area we have not yet touched on in our writing is that of the Investment Research produced by large Wall Street firms, also known as “Sell-Side” research. You might be wondering how much of this Wall Street research we use here at Globescan? The answer is close to none. The reason is that while, at first glance, this research might appear to be a valuable addition to an investment process, the sad truth is that most of this research is just another example of Wall Street’s fixation with selling rather than investing – after all, it literally is in the name: SELL-side.
For those not familiar with industry terms, there exists within the investment industry a division between so-called sell-side firms and buy-side firms. Sell-side firms are typically the large banks that sell their services to investment firms, and buy-side firms are those investment firms that are being sold to. And one of the key products the sell-side sells is investment research; they have hundreds of analysts pouring over companies and writing reams and reams of research, while the buy-side may only have a small team of their own analysts and supplement that team with this Wall Street research.
The reason we bring this up now is that increasingly a lot of this sell-side research is also being made available to retail investors through their investment brokerage platforms, who are in turn paying the sell-side on behalf of their clients (even though you never see this cost). With the ever-increasing distribution of this “research”, it is important that we discuss the validity of the product.
As with most products, one of the most important things to understand is the motivation for its creation. Sell-side research is produced for two main reasons: 1) As a product to be sold, and 2) To generate trading activity and revenue for the firms who produced it. In contrast, buy-side firms typically produce research solely for their own use in order to generate investment returns. Said another way – sell-side research makes its money by selling investment ideas, whereas buy-side research makes its money by investing in investment ideas.
The difference in motivations leads to some very negative results.
Sell-Side Research Is Short-Term Focused
As we have talked about before, short-term market movements are impossible to predict and as a result, any research that tries to do just that isn’t going to be of much use. Actual useful investment research tends to be long-term in nature, analyzing the moat-protected future free cash flows that an asset is likely to produce over its lifetime.
Unfortunately for Wall Street, this type of “useful” research does not change much quarter to quarter or often even year to year. Think about this logically, if you formulate a long-term thesis for a company like Apple or Amazon, possibly due to industry trends that are going to play out over many years, then the chances that this multi-year story will change significantly in any given quarter is very slim. But what good is research for the sell-side if they can only sell it once a year?
Goldman Sachs does not want to just sell one research report a year when instead they could sell daily, weekly, monthly, etc. updates to their clients. So, while they may occasionally produce a long term piece, the majority of output is churned out month by month or quarter by quarter, enabling them to justify charging regular fees for it in perpetuity.
And not only that but remember that the second reason for the sell-side writing this research is for them to generate trading revenue by persuading people to buy or sell. A yearly update would likely only result in yearly trading revenue as a result of the research, but if they’re producing substantial research every month on the same stock, that’s far more likely to incite some end clients to decide to buy or sell – resulting in more trading revenue (bear in mind that even with zero commissions, there are still many ways these firms can and do earn substantial profits from every single transaction).
As such, sell-side research has evolved to be very short-term in nature – simply explaining what happened in the last quarter and how they think the next quarter will look. They aren’t interested in where a company’s earnings and profits will be in 5 or 10 years’ time, they are interested in where they’ll be in 3 months’ time.
In addition, not only is the research itself short term in nature, so is the duration of the ultimate recommendation – often changing multiple times a year with whatever the overall market is doing. This is because the research and recommendations need to change in opinion in order to ensure trading and transaction volume for the firms. So, the research needs to be sufficiently impactful to result in some activity, it needs a buy or a sell. Therefore, ‘Hold’ recommendations aren’t popular or very common with sell-side research. After all, there’s no money to be made in just holding something… unless of course, you’re the actual end investor, in which case that is often exactly what you should be doing.
And sadly, most of the investment industry encourages this short-termism. Most fund managers are judged on quarterly performance, and analysts are judged on their quarterly picks. If your bonus is tied to quarterly results, then human nature will drive you to that as your investment horizon and time frame, regardless of whether that is the best strategy or not for the ultimate end client.
But this focus misses the point of investing entirely. If you are buying a stock, you are buying a stake in a company. The real intrinsic value of any business or any company does not change a huge amount in a few months (unless something truly transformational happens, which is rare).
This again has a knock-on negative effect on the buy-side investment firms who choose to rely on sell-side research as a key part of their decision-making process (which is most investment firms and RIAs): they are constantly being fed short term views, research and strategies and so they themselves naturally end up being more short term themselves in their decisions. The whole ugly cycle of short-termism continues.
Sell-Side Research Is Consistently Wrong And It Doesn’t Seem To Matter
When it comes to projecting share prices over these short time horizons, it’s not at all surprising that, the track record of sell-side analysts is random at best and consistently wrong at worst. To be clear, we are not suggesting that we could do any better, but we are suggesting that people should simply stop trying.
But they will not stop trying anytime soon because it ultimately doesn’t matter if sell-side research is right or wrong, they are getting paid regardless of how accurate the research is. Once again, as is often the case in the investment industry, selling a product takes precedence over generating investment returns.
But what if they short term focused sell-side analysts could actually predict prices and movements reliably? There is still one more fundamental issue here to consider: Sell-side analysts typically cover one industry or basket of companies. For example, a bank analyst will follow banks, a retail analyst will follow department stores, etc. Each of these analysts is producing their own buy and sell ratings based on their coverage universe, which is in isolation of the rest of the market.
So, a buy rating from the bank analyst is not considering all the other non-bank companies in the market that might be even more attractive as investments. Said another way, sell-side research does not consider opportunity costs – making 10% in a bank when you could have made 20% in a tech company for similar risk is a 10% loss in opportunity cost terms.
And it gets worse, remember also that there are a number of industries and sectors that are fundamentally unattractive as sources of investment opportunity. For example, any industry dominated by the price of a volatile and unpredictable commodity, or any industry where the participants have no control over their own returns because regulation is so severe. But sell-side analysts still have to cover these sectors, and they often still have to produce a number of ‘Buy’ ratings regardless of how fundamentally unattractive these investments may be compared to other opportunities.
Putting it all together, one of the most ubiquitous Wall Street products that presents itself as a tool to help you generate returns is in fact targeting entirely different outcomes: research fees and trading revenue. Sell-side research is simply another product to market and sell. And sadly, it is also one that perpetuates and worsens the short-termism that is so destructive in the investment industry as a whole.
As always, the best approach to investing is to do the hard work of understanding the underlying company one is considering investing in. Relying on research produced by those with motivations at odds with your own is not the best strategy to achieve consistent long-term returns.
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