Talking it up

Vincent Hung shares his experience of working in equity research.

Equity research can be distinguished through the sell-side (investment banks and brokerage firms) and the buy-side (investment managers). For this article, it will concentrate on the sell-side although many of the points raised here are applicable to the buy-side.

The equity research department sits on the equities trading floor along with sales and trading. The purpose of analysts within equity research is to analyse the shares of companies in certain sectors and provide investment recommendations on them. Based on certain factors, analysts make calls such as buy, hold or sell. For example, an analyst covering the banking sector will write research on companies such as HSBC and could say the stock is a buy for various different reasons.

Research produced by analysts goes out to two different sets of clients. Firstly, they go to sales and trading who use these calls to generate execution and trading revenues. Salesmen rely on these calls to provide investment ideas to their clients. Traders need research analysts' calls to increase trading activity in stocks so that they can obtain commission on order execution and generate revenue through market-making. Proprietary traders utilise these ideas to generate trading revenue for their firm if the recommendations are correct.

Secondly, research analysts distribute their research directly to their clients. These clients can vary from asset managers like Fidelity to hedge fund managers such as Marshall Wace. Research analysts must communicate with their clients whenever they release research in the hope that these clients will trade through their firm. But also they must build and uphold a profile within the industry for having the necessary sector intelligence and the ability to make the right calls.

How do equity research analysts make investment recommendations?

Analysts make investment recommendations on companies only after conducting in depth research on a company. They not only know the company inside out but also the sector in which they operate. An analyst making a recommendation on Thomas Cook knows about the company in substantial detail but also the travel and leisure sector in which they operate. Analysts conduct either top-down or bottom-up analysis when they are analysing stocks. Top-down refers to looking at the broader level mainly such as macroeconomic conditions or the sector and then they will move to the bottom (firm level) which involves fundamental analysis. Bottom-up is the reverse of this and concentrates mainly on the fundamentals of the company such as the balance sheet, income statement and cash flow forecasts. If an analyst decides whether the current value of the firm is undervalued in relation to a firm's long term valuation then they might recommend the stock as a buy. An analyst will attempt to forecast the financials of the firm and this plays a part in valuing a company and deciding whether the company's current share price is undervalued compared to its long term value.

When valuing companies, there are countless ways of doing this. The simplest method that many analysts use is the P/E ratio (Price-earnings ratio); this is the ratio of the price per share to earnings per share and a reciprocal of the earnings yield. When using this ratio you compare with other companies within the sector and if it trades at a discount to competitors it may be undervalued. But this method is very limited as the company may trade at a discount for a good reason. Other methods include DCF analysis (Discounted cash flow), EV/EBITDA (Enterprise Value to Earnings before interest, tax, depreciation and amortisation), price to book ratio and FCF yield (Free Cash Flow). These are just some of the ways in which analysts may value stocks.

Issues within sell-side equity research

The main issue within sell-side equity research is maintaining an independent view on companies when there are many conflicts of interest. The reliance on company management to obtain information about forecasts and many other types of data means that access to management is crucial. If you ended up putting out a sell note on that company then the next time you call, they may not be as open to providing you with sufficient information.

Maintaining a good relationship with company management is important, not just for the accuracy of your research but to generate business for other arms of the investment bank. Dependent on the bank, secondary equity trading does not generate sufficient revenues and firms try to plug this short fall by drumming up corporate finance business such as M&A or equity issues. They do this by attempting to become the company's corporate broker, this means the bank advise the company about what is happening in the market and any opportunities that are available for them. If there is an opportunity, the corporate broker is hired by the company to carry out these services. Most corporate brokers charge no fee to their clients in the hope of creating corporate finance business.

In order to gain and retain a corporate brokership, the research analyst plays a substantial role. For example, putting out a sell note on a company you are broker to may infuriate management and result in your bank losing the corporate brokership. This constrains an analysts' independence and can only lead to inaccurate research.

Featured in all equity research reports are disclosures, usually on the last page. These detail how many companies have been rated a buy, hold or sell and next to that how many of these calls are made on companies the bank is broker to. It is very rare to see a large number of sell notes being written on broker companies, which suggests the lack of independence within sell-side equity research. Although, you could argue that the bank is broker only to companies which are genuinely good companies.

The conflicts within equity research have seen the emergence of firms that produce independent equity research. These can be split into two categories; firms that have a business model based on cash equity trading such as Exane BNP Paribas and firms that charge for research like Edison Investment Research, ensuring independent viewpoints. Exane BNP Paribas contest that their research is independent because of the absence of a corporate finance division and rely solely on generating trading revenues.

Moving into the buy-side of equity research such as working for asset management firms or hedge funds is another route of producing fully independent research, although the coverage of stocks will be much wider, possibly resulting in less accurate research.

The appeal of sell-side research and routes in

Sell-side equity research is a profession under significant pressure but it is one that is still very attractive. Working in equity research allows you to develop skills within accounting and finance and detailed sector knowledge. It also provides you with greater analytical and communication skills. Being on the sell-side allows you to communicate with many different sets of clients such as typical long-only asset managers or hedge funds.

The skills you develop within equity research are transferable to different divisions such as sales or corporate finance, although many corporate finance analysts tend to move into equity research due to a better work-life balance. There are also opportunities on the buy-side such as moving to asset management, private equity or hedge funds.

The main routes into sell-side equity research are through graduate programmes offered by all the main investment banks but places are limited because research divisions are substantially smaller than others such as sales. There are many other routes into equity research if you cannot make it in via the graduate route. One of the most popular methods has been to do an ACA at a Big Four accountancy firm and then move to a research department once you are qualified. Many of today's research analysts have moved into the profession after obtaining their ACA qualification. Other ways of moving into equity research include working in equity research on the buy-side, corporate finance, other front office areas of investment banking and strategy consultancy at one of the top firms.

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