What Constitutes Quality Research?

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According to Thomson Financial, the annual volume of equity research reports generated has grown to approximately 1.1 million up from 190,000 a decade ago. From this multitude of available research, investors must select the research that provides the maximum value. Therefore, to differentiate between the various providers, investors need to evaluate equity research on certain key attributes. These primary attributes include:

Quality

While quality of research is highly subjective by definition, investors nevertheless use broad parameters to judge the quality of equity research. Some of the key parameters are outlined below along with their overall rank in the list of institutional investors’ priorities:

What investors really want from equity research firms
Parameters

Overall Rank

Industry Knowledge

1

Integrity/Professionalism

2

Accessibility/Responsiveness

3

Useful and timely calls and visits

4

Management access

5

Special services

6

Written reports

7

Independence from corporate finance

8

Communication skills

9

Financial models

10

Stock selection

11

Earnings estimates

12

Quality of sales force

13

Market making/execution

14

Primary market services

15

Source: Institutional Investor

Given the wide spectrum of variables that investors use to evaluate equity research we have classified the parameters into the following categories:

Company and industry insights

Apart from assimilating and disseminating information, research is also judged on the basis of valuable insights that the analyst provides on the underlying company or the industry. Drawing upon their industry expertise, sell-side analysts have a unique perspective to offer which investors are often interested in. This is consistent with the feedback provided in the table above, where industry knowledge and insight is deemed of primary importance to institutional investors.

Fast, proactive service

From time-to-time, companies announce information (e.g. change in management, unforeseen contingencies, revenue and earnings guidance and releases, etc.) that has a material impact on the stock price. Following the release of such information, an analyst has to issue his perspective on the effect that such events would have on the stock. Investors value timeliness, responsiveness and clarity of reasoning when evaluating research quality. In addition, investors value research from analysts who are easily accessible and responsive to the specific queries of the client.  These attributes are ranked 3rd and 4th by investors as is evidenced by the above table.

Clarity of communication

One of the characteristics of the most influentail equity analysts is their written and spoken communication skills.  Institutional investors value writtent reports that are both clear and well researched.  They also favor analysts who can express their views effectively in a direct  conversation, answering specific client questions, and brainstorming about the prospects of a company or industry.  These attributes were ranked 7th and 9th in the above table.

Network of quality information sources

Over time, research analysts develop a network of contacts in the sector they follow. These networks constitute an informal knowledge base that the analyst refers to as a back-up source of information, to help verify information discovered when company due diligence is performed. This network consists of industrial experts, thought leaders, consultants, etc. Some analysts also perform surveys of suppliers and customers to validate the projections and conclusions of company management.  Of course, one of the most basic information sources that analysts draw upon are the management of the companies under coverage.   Investors value analysts that have such extensive networks to draw upon because their research often provides greater clarity and depth about the future prospects of the companies under coverage.  The table above refers to these characteristics as management access (ranked 5th), special services (ranked 6th), and primary market services (ranked 15th).

Analytical rigor

Given the information overload in the public domain, equity analysts have the critical job of integrating all the information in their analyses. Analysts sift through a company’s financial statements and use sophisticated modeling techniques to arrive at an estimate of the underlying company’s valuation. Investors value the analytical rigor that goes into the process.  Institutional investors ranked this factor 10th in the above table.

Track record

In judging the quality of research, investors also look at the accuracy of an analyst’s forecasts in the past. There are some organizations (Starmine, Investars, MarketPerform etc.) that track the accuracy of analysts’ forecasts and thereby provide investors with a ready reference to benchmark analysts along this attribute.  Investors deem the accuracy of an analyst’s stock recommendations and earnings forecasts as 11th and 12th.

Objectivity

Analyst objectivity is the cornerstone of good equity research. Due to their close interaction with company management, analysts are often swayed by the management’s vision-something often termed “falling in love with the manager’s story.” Additionally, conflicts of interest that exist between the two constituencies that the analyst serves, that is, investors and companies, could also cloud the analyst’s objectivity. Some of the potential conflict of interest scenarios that could compromise an analyst’s objectivity are as follows:

Whatever the case, investors expect research analysts to provide them unbiased research. Investors leave it to the analysts to navigate these ethical issues and produce objective research.

Cost

Quality and objectivity apart, equity research must also be cost effective. The returns from investing in research should justify the investment. While evaluating and differentiating between various research providers, whether sell-side or independent research, institutional investors use cost as an important factor in making their choices.

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