Viewpoint

The Proper Care and Feeding of Great Analysts

What makes great analysts so great? And can others learn their secrets?
BY JAMES VALENTINE, CFA

o great analysts possess specific skills and knowledge? I set out to answer this question by interviewing dozens of practitioners, and from that work, it became clear that they have mastered six skills: (1) Properly identify and monitor the critical factors most likely to influence a stock. (2) Create or obtain financial forecasts more accurate than consensus. (3) Leverage financial forecasts and valuation methods to derive superior price targets. (4) Consistently understand where consensus is wrong and the catalyst most likely to move a stock. (5) Clearly and succinctly communicate insightful stock recommendations. (6) Master interpersonal and organizational skills. For sell-side analysts, a seventh skill is also required: (7) Successfully manage their franchise as an ongoing commercial enterprise.
Identifying and Monitoring Critical Factors

sell-side analysts who have more accurate earnings estimates also tend to have more accurate stock picks.1 Regardless of your method, the key is to ensure that your forecast is more accurate than consensus. Self-assessment of this ability is often easy to do. Buy-side analysts should check their performance using in-house metrics, and sell-side analysts should regularly reference objective third-party services (such as StarMine, which tracks analysts earnings accuracy). If data isnt available, analysts should keep records of how well their estimates perform relative to consensus by simply recording both numbers in a worksheet each time a revision is made to the model. Remember the old management adage you cant manage what you dont measure.
Superior Price Targets

Do you have a list (written down or in your head) of critical factors that you watch for each stock in your assigned universe? If so, how many factors are on that list for a typical stock5, 10, or even 20? Great analysts identify critical factors and then narrow down their list to 24 per stock. This trait allows them to do two important things: (1) dig more deeply than their competition on a few key factors so as to develop a better view than consensus, (2) and avoid wasting countless hours on all of the noise that surrounds factors not likely to move a stock. No single irrefutable method exists for identifying a factor as critical, but one easy test is to ask whether its likely to move the annual consensus forecasts by more than 5 percent. When the answer is categorically no, then its probably not critical. When the answer is not clear, more research needs to be done to put it into a critical or noncritical column. As a self-assessment check, ask whether you routinely identify and monitor 24 critical factors per stock. If so, do you spend the majority of your research time on these factors, especially those for your high-conviction stocks?
More Accurate Forecasts

Just because youve mastered forecasting earnings or cash flows doesnt guarantee alpha generation. Great analysts possess the additional ingredient of applying the appropriate valuation multiple to their forecast. When making buy recommendations, the rookie mistake is to simply apply a favorable multiple to an optimistic forecast, which often ends in disappointment when such a level isnt warranted for the current portion of the economic cycle or companys life cycle. Great analysts take time to understand why their stocks command current valuation multiples (relative or absolute) and why they have fluctuated in the past. For stocks that dont have a history or are forging new growth rates, analysts understand the level the market pays for comparable companies, sometimes requiring in-depth research of unrelated companies or sectors. Analysts can assess their ability in this area by asking whether they know the relative and absolute peak, trough, and average valuation multiples for their stocks (or those with comparable growth rates) going back at least three economic cycles.
Assess Consensus and Have a Catalyst

Do you build, borrow, or buy your financial forecasts? Sell-side and many buy-side analysts build them from the ground up with complex models, yet some buy-side analysts simply tweak the consensus. Studies have shown that
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The key to generating alpha is having a more accurate view about a future stock price than the market. This can be done on a consistent basis only if the analyst has an edge over the consensus thinking (while staying within ethical and legal boundaries). Analysts can determine whether their call has an edge by using what I call the FaVeS framework. Specifically, their call needs to be superior to consensus in at least one of these areas: (1) Forecast: financial forecast superior to the markets. (2) Valuation:
1 Roger Loh and G. Mujtaba Mian, Do Accurate Earnings Forecasts Facilitate Superior Investment Recommendations?, Journal of Financial Economics (2006).

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valuation methodology or valuation multiple superior to the markets. (3) Sentiment: forecast of investor sentiment superior to the markets. You dont need to have all three elements, but if your call has none, its probably of no value. This sounds harsh, but unfortunately, too many calls are made that lack any of these elements, which is a waste of effort for the person making the call and those who are asked to make the trade. Its not unusual for a rookie analyst to seek recognition for simply parroting managements guidance as the key tenets of his or her stock call even though the call doesnt have any of the above elements to make it superior to the markets view. Even if a call has one of these elements, it should only be made when theres also an identifiable catalyst thats likely to change the consensus view during the investment time horizon. To evaluate this area, go back to your previous 510 stock calls and ask which of the FaVeS framework elements each call possessed and whether the catalyst(s) was (were) identified in advance (try to use documents created at the time of the call to avoid letting your mind revise history).
Communicate Your Insight

provide insights always in an ethical manner as well as influencing others to act on stock recommendations. An equity research analyst should strive to master eight key influencing skills: (1) self-awareness, (2) communication skills (both speaking and writing), (3) awareness of others needs, (4) listening skills, (5) adaptability, (6) network building, (7) confidence, and (8) credibility. We all have the same 24 hours a day to generate alpha. The best analysts know how to use this time better than their competitors. Specifically, they approach their job on the offensive rather than playing defense. This means they only take meetings, calls, and read e-mails or reports from individuals who add value in assessing the 24 critical factors that drive their stocks. Unfortunately, too many analysts try to scan everything as part of a coveryourself strategy, but this approach doesnt provide them with the time to find ideas that can separate them from the pack. Self-assess yourself by asking how many hours per week you are proactively researching the few critical factors you think consensus is wrong about. If the answer is less than 25 percent of your time, youre probably spending too much time playing defense (or youre still new to the job and learning the basics of your companies).
Know Your Strengths and Blind Spots

Unless you own your own firm, youll need to communicate your ideas to be recognized and eventually rewarded for your efforts. Dont assume this applies only to sell-side analysts, because, in addition to buy-side analysts being evaluated on their stock-picking ability, another important consideration is the need to get their ideas into the portfolio. To help analysts assess whether the content of their message has value, Ive developed the ENTER framework. All good stock communications should have these elements: (1) Expectational: provides insights about the future, especially catalysts likely to move the market toward the analysts out-of-consensus view. (2) Novel: answers the question Whats new or unique thats not already known by the broader market? (3) Thorough: ensures that the view is backed by sound research, not only a hunch. (4) Examinable: provides decision makers (portfolio managers or clients) with the information used to make conclusions. (5) Revealing: exposes risks and acknowledges a conviction level. Self-assessment of this skill is relatively easy. Take the documents you used for your prior 510 stock calls (reports, e-mails, or scripts for presentations) and see whether they possess these elements. The more you can include, the more value youll add to the consumer of the message.
Interpersonal and Organizational Skills

The U.S. Department of Labor has an exhaustive list of skills describing a financial analyst, ranked in order of importance from highest to lowest. The list is respectable, except that influencing skills are ranked too low (social perceptiveness is ranked 15th, and persuasion came in at 17th). Great analysts are those who can influence others. This includes influencing information sources to help

Few analysts have complete mastery of the six skills mentioned at the beginning of this article, but great analysts know where they excel and where they need help. At AnalystSolutions, weve developed a self-assessment tool to help analysts understand how their views differ from senior analysts. As with any profession, if you know the requirements of the job and strive to master each of these areas, your probability of success increases. Its still a bit early to draw sweeping conclusions, but based on those who have taken the assessment to this point, preliminary findings help show how experienced buy-side and sell-side analysts differ from novices. When compared with novices, senior equity research analysts thoroughly understand inputs to their companys production or creation of their service and the primary markets to which the company sells; when recommending a stock, place more focus on the factors that distinguish their view from consensus; are more comfortable articulating the strategies of all the companies they follow and how they differ from their competitors; when their price target materially differs from the current price, they know where their assumptions differ from the markets view; fully understand the peak and trough valuation levels for their companies going back at least 10 years; are more realistic in appreciating that even the best stock pickers dont have 100 percent of the information necessary to make a stock call.

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For both buy-side and sell-side analysts, as experience increases, so does agreement with the following statement: When recommending a stock I like, I focus primarily on the factors where my view is distinctly different from consensus. If you take away only a single concept from this article it should be this one: Generating alpha is all about determining where consensus is wrong a point that often gets overlooked by less experienced analysts. Among the sell-side analyst population, as their experience increases, two things become clear. First, they gain more job satisfaction from speaking with clients. Second, the more experienced they are, the more they disagree with the following statements: (1) I build only the bare essential financial model necessary to uncover anomalies and trends. (2) I have a generally calm disposition. (3) Im exceptional at finding common ground in times of conflict. While additional insights emerge as more analysts take the AnalystSolutions assessment, the initial mosaic shows successful, experienced analysts as determined to identify points where they differ from consensus, which they do by understanding their companies as well as how current valuation differs from the past. In terms of personality, they tend to be headstrong, independent, and easily roused. This picture is fairly consistent with my observations of successful analysts. I was initially

surprised by the solitary qualities that emerged, but on further consideration, this job isnt a team sport. Although there may be investment committee meetings, lets face the fact that most of the work typically conducted by analysts is independent of colleagues (e.g., most firms dont have a team of telecom analysts). Im not saying analysts must be introverted to be great. Rather, they work and think independently to generate alpha.
Conclusion

We were all rookies at one time. But how do we know we are becoming or have become the best analyst we can be? If youre looking for a way to gain an edge (or more of an edge), set time aside to identify which of the six primary skills are your greatest strengths and which are in need of improvement. After all, analyzing stocks is mostly a relative game. When youre recommending a stock you like, its often being sold by someone who thinks youre wrong. The key is to be armed with the skills and knowledge to ensure youve arrived at the more accurate conclusion. James Valentine, CFA, has 16 years experience as an equity research analyst and is founder of AnalystSolutions as well as the author of Best Practices for Equity Research Analysts.

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