What’s behind the door?
Earnings season in the United States is in full swing. I love this time in the markets, as the most important companies in the world issue their quarterly report cards.
Let’s focus on what it means to “beat expectations” or, if you really want to sound fancy, “beat the street” – a reference to Wall Street although Maude Street in Sandton would be applicable for JSE companies.
The market works because of information flowing between companies and investors. The investors form conclusions based on the available information as well as their own research and analysis.
A key part of this ecosystem is the sell-side analyst community. Most of their work is done behind closed doors and retail investors never get to see it.
The numbers and the story
Within any results announcement, companies will disclose a highly regulated set of financials (governed by accounting rules, such as International Financial Reporting Standards (IFRS) in most countries including South Africa, or Generally Accepted Accounting Principles (GAAP) in the United States).
They will also provide supporting commentary and a presentation, which you’ll often find on South African websites as an “analyst presentation”. You’ll be amazed how much information is available on the investor relations section of listed company websites. In addition to analyst presentations, companies sometimes host investor days to update the market on what’s going on in the business.
In the United States, they keep things simpler. The basic filings include key metrics applicable to the company (like Average Revenue Per User (ARPU) for a platform business) and the full financials are less of a focus than they are in South Africa. This is just my opinion based on what I’ve observed from reading offshore results.
I’m not sure that the extended financial statements are of use to many people. I know how to read them because of my academic background, but I probably focus on 30% of what is reported. Unfortunately, the rules are so complex that they have almost become less useful as a result.
There is a great deal of skill in unpacking the intricacies of a financial result. The art is to look for what the company isn’t telling you. That’s where the sell-side community comes in.
What does the sell-side do?
Sell-side analysts traditionally worked for stockbrokers, providing research to asset managers and hedge funds who would show their appreciation by trading through that broker. The analysts were the face of the brokerage to the institutional investor community.
As a result, there was a time when they could write their own cheques. Like the football stars of finance, they could even be paid eye-watering sign-on bonuses. At around the same time that I finished my articles, while dreaming of becoming a sell-side analyst, the market fell apart.
When the JSE started going sideways and trade volumes fell, brokerages started to lose money. Suddenly, the expensive analyst in the corner making R5m a year (and more) looked like a pimple that needed to be squeezed. Being 4th in the Financial Mail rankings wasn’t going to cut it anymore.
Job losses in the industry were significant. The best and the luckiest survived, while others had to reinvent themselves. I watched it happen in my final year of articles, which is why I ended up going the corporate finance route instead. The only way to have less work-life balance than a sell-side analyst is to work in corporate finance. Trust me.
It feels like things are looking up for the sell-side. Regulatory changes are forcing asset managers to directly pay for research, rather than paying with “soft dollars” via routing brokerage through the research house.
This makes it easier to measure the value of the research. It also means that independent analysts can flourish, like Anthony Clark in South Africa (who you should be following on Twitter @smalltalkdaily), a specialist in JSE small- and mid-caps that are often ignored by other analysts.
Most analysts have stayed behind closed doors, focusing exclusively on the institutional community with little or no public profile.
Does it give an advantage to institutions? Yes, although not to the extent you might think.
Is it an unfair advantage? Is anything in life fair?
How can individual investors close the gap?
Here’s a little secret: many analysts are either plagued by conflict of interest, or simply not skilled at accurately predicting the results of companies.
Analyst consensus is just an average of what the analyst community is expecting. There are significant outliers. Earnings are rarely in line with consensus, which tells you that the sell-side community is wrong on average.
Institutions pick out the analysts who are accurate most often and reward them accordingly.
I’ve read numerous sell-side reports at various points in my career. Many of them go something like this:
- Snappy title, fancy logo, “please remember how smart we are” blurb
- Quick summary of results, for asset managers too busy (or disinterested) to read the full company filings
- Useful section on market growth vs. the company, with a discussion around market share and trajectory
- “Look at this chart I’ve been showing you for 3 years which proves I’m right”
- “Here’s a new chart to distract you from the one I took out, which had been useless for 3 years”
- Several pages of legal disclosure
This is obviously a tongue-in-cheek view on things but there’s a lot of truth in it. The best analysts are incredible, however. If ever there was an industry with winner-takes-all economics, this is the one.
In practice, price target updates by respected analysts are often catalysts for share price action. When you see something jump 3% by 11am and there’s no news flow, I can almost guarantee that an influential analyst has put out a report.
If you’re in the tent, you’ll receive the report or at least an update that such a report exists. The vast majority of investors aren’t so lucky.
Can you do well in the market without access to this research? Of course you can.
If you are serious about investing, you need to be on Twitter. There’s no debate here. The FinTwit community is extremely powerful.
Asset managers. Analysts with anonymous accounts. Top global thinkers. They are all on Twitter.
If you combine FinTwit with a strong desire to learn and a habit of reading both widely and deeply, you can bring yourself closer to a level of institutional knowledge. My intention with The Finance Ghost over the past year or so has been to help individual investors close that gap.
Success comes to those who fully commit themselves to learning and immersing themselves in an ecosystem that has become incredibly powerful for individual investors. You should be listening to podcasts and reading mailers. Follow those who are willing to share objective, sensible views. Follow people you don’t agree with. Follow people who annoy you.
It all helps you form a robust view on things. Over time, that approach pays dividends. Literally.
Part of that investor ecosystem is Ghost Mail, which I send out every Tuesday morning. It’s free and you can sign up here.