The Globe and Mail, Report on Business
Published June 28, 2008

“We do our own independent research.”

That's what all investment managers tell their prospective clients. It is a point of pride and is meant to distinguish them from other managers. It's also a necessity if there is a consultant involved, because they invariably ask "what proportion of research is done internally?"

What I'm referring to is the split between the equity research done internally by an investment manager (buy side of the Street) versus externally by analysts at brokerage firms (sell side or simply the "Street"). In reality, all "buy side" firms, whether they have one or two people or a global research department, use the "sell side" to some extent. But the amount of dependence varies widely.

I learned that early in my career when I was an analyst with the brokerage firm Richardson Greenshields. Some portfolio managers relied on my earnings estimates (which I agonized over) and stock recommendations (Buy CP and Power Corp. ...sell Federal Industries). But others like Ira Gluskin and the Trimark team (Bob Krembil, Dennis Starritt and Bill Kanko) could care less what my recommendations were. They wanted to know how the industry worked, where the company was at in its capital spending cycle and/or who the competitors were. Each institutional client was looking for something different to fill out their own research process.

On the surface, sell and buy side analysts look the same. They are all smart, curious and well...analytical. They study the same subjects - public companies - and are often in the room together when meeting with management teams. But the job they do is really quite different.

On the sell side, a good analyst doesn't have to make money for his/her clients. It helps if their stock picks are well timed, but there are lots of other things they do that are useful to their clients, the buy side analysts and portfolio managers.

They may have a good spreadsheet on a company, extensive contacts with management and industry insiders and/or a unique understanding of a complex industry. Street analysts often provide buy siders with opportunities to meet management. Some even organize plant tours and conferences in their area of specialty.

Unavoidably, they tend to be more short-term oriented than portfolio managers. The revenue model at a brokerage firm is dependent on doing trades and winning investment banking assignments. Quarterly earnings estimates, in-depth analysis of short-term events and precise recommendations feed into that model.

Analysts on the buy side have a much different existence. First of all, research may only be a part of their job. In many firms, the stock analysis is done by people who wear multiple hats - fund management, marketing and client service. But when it comes to the bonus cheques for their research work, only one thing matters - did their stock picks make the clients money?

In my experience, the lack of an external marketing imperative makes the buy side a quieter, less urgent place to work. The nature of portfolio management is such that there is considerably less time spent on short-term events and current news. Most often the research being done leads to no new holdings, no trades, no action, which is okay. To quote Warren Buffett: "Wall Street makes its money on activity. You make your money on inactivity."

There are a few other observations I can make.

It is hard to know more about a large-capitalization company than a Street analyst. That is their sweet spot. But for smaller companies, the buy side often has an advantage. Small-cap companies don't have the same revenue potential for an investment dealer, so analysts can't spend too much time on them. On the other hand, investment managers, who own shares on behalf of their clients, have a high incentive to know the company well.

Generally portfolio managers don't care as much about the stock recommendation (buy, hold, sell) as brokerage firms do. A "buy" from a respected analyst certainly will get a manager's attention and may spark a fresh look, but that in itself isn't enough to make a change. Sell recommendations and more radical views garner the most interest.

The challenge for brokerage analysts, however, is that extreme views come with a high degree of career risk. If they are wrong or too early on their call, it is never forgotten. That's particularly true of a "sell" that kept going up. And managements of the companies they follow tend to be less accommodating to analysts who are operating outside of the consensus.

Street analysts have great financial models and do extensive valuation work, but they are sometimes lacking in their understanding of the operating characteristics of a business - what makes a company tick. Reflecting back on my early days as an analyst, I realize how little I knew about company dynamics, which is scary given that I was highly ranked at the time.

Since going to the buy side, I've never looked to the Street to detect a major change in a company's fortunes. The analysts are poorly positioned to do so, given their focus on the quarter-to-quarter detail and their reliance on "management guidance." As a former colleague said to me in 1999, "the issue isn't whether Intel's earnings are going to be down 3 per cent over last year, it's whether they'll be down by half." Analysts don't often catch the 50-per-cent changes, although few of us do.

In the end, each side understands its role.

The sell side provides a valuable service to the buy side, where the ultimate responsibility for stock selection lies. Both are a big part of the money management process. Don't let your investment manager tell you otherwise.