The research analyst analyzing stocks and sectors has an important role to play in the capital markets. The reasons are not far to seek. The clients who put buy and sell orders based on the analyst views rely on the expertise and integrity of the research analyst. The broking house or fund house that employs the analyst also relies on their capacity to give unbiased advice. Above all, the stock market mechanism is dependent on the skills and the integrity of these analysts in aiding the process of price discovery. Analysts are supposed to make the stock markets safer and healthier with their expertise and unbiased advice. That is why their role is larger and more pivotal than many other players in the capital markets.
Categories of Analysts in the Market
Broadly, there are four types of analyst that operate in the capital markets and one needs to be familiar with the role of each one of them.
- Sell side analysts are those analysts affiliated to broking and investment banking houses. They specialize in sectors (industries) and give their buy / sell recommendations to their clients. These are confidential recommendations and hence are not circulated among the public. The expectation is that good recommendations will be instrumental in generating bigger fees for the broking house.
- Buy side analysts are affiliated to portfolio investors, mutual funds and even family offices. These are in-house analysts and portfolio managers normally rely on in-house and external research to get a spread of views. Buy side analysts track a larger number of stocks and their role is to improve the investment decision process.
- Independent analysts are not affiliated to either the buy or sell side but express an independent opinion on a stock. Their research is available for a fee and that is revenue model on which these analysts operate. Independent analysts must demonstrate their knowledge, skill and integrity levels to quality for the role.
- Credit analysts are not exactly equity analyst but focus more on debt. They focus more on the default risk and interest rate risk of bonds. In the last few years, with the large number of defaults, these credit analysts have become an important part of the capital markets.
What The Analyst Looks At Before Giving A View?
Equity analysis is a broad and multi-dimensional activity and the analyst is required to look at a cross section of factors before arriving at a view or a decision. While the specific factors may vary, here are the broad factors that an analyst looks into.
- Domestic macro factors and sensitivities impacting the stock like inflation, GDP growth rate, index of industrial production etc.
- Global macro factors like the exchange rate, global data flows like US jobs, US GDP, China monetary policies etc.
- Industry level factors like entry barriers to a business, unique brand value created, demand and supply of the sector, major disruptions, government policy etc.
- Industry level financials are also looked into in detail and these include margins in the industry, sales and profit growth, dividend yields, sectoral P/E ratios etc.
- Company profitability which includes operating profitability, asset turnover, return on equity and the return on capital employed, net profit margins etc
- Company solvency in terms of the quantum of debt, interest coverage ratios, debt service ratios, vulnerability to rate risks etc
- Company liquidity position in terms of working capital management, time to convert product into cash, debtor management, vendor management etc
- Qualitative factors that can impact the valuation of the company and these include parameters like the quality of management, standards of corporate governance, continuity policy of the top management etc.
- Channel checks to verify that the company is giving numbers that are borne out by industry practices and sector level numbers
It is based on all the above factors that the analysts eventually forms an opinion about the stock and gives a buy or sell recommendation.
Process Flow That the Analyst Must Follow
The job of an analyst is not just about the factors and data points but also about the process followed to elicit all the required information. Normally the following is the process flow that must be followed by an analyst.
- Do the secondary analysis of the company thoroughly and that includes the financials for the last 8 quarters and the last 5 full years. The focus must be on growth, margins and efficiency on all the parameters
- For secondary sources of information, the analyst can also rely on parameters like exchange filings, newspaper clippings, international filings (like in pharma), industry association data etc.
- The next step is to set up a direct interaction with the management of the company. This is normally done in two stages. The meeting must be ideally preceded by a detailed questionnaire so that the management is prepared with the answers. At the first level, normally, you meet with the operational and product heads.
- The second level meeting is normally with the CEO and the CFO of the company. This is more to understand their responses to questions which the operational managers could not provide. Additionally, this meeting is also used to get more clarity and insights on the vision of the company, its future plans, its positioning etc.
- Based, on the secondary and primary sources of information, the next step is the report preparation. The analyst is expected to use discretion and integrity and dealing with information and work out projections accordingly. Based on the analysts, the detailed projections are worked out.
- The next step is the all important step of channel checks where a lot of the projections you made are ratified through your networks that include key clients, dealers, other analysts, fund managers etc. This is an important step as it ensures that your projections are as close to the real situation as possible.
- Once the ratification is done, the last step is to arrive at the valuation of the company and then decide on whether the stock should be downgraded, upgraded or just retain a neutral view.
Asset Classes That Analysts Typically Cater To
While analysts are normally associated with equities alone, they can offer their services to a host of other asset classes too. Here are some of the common categories of assets that are evaluated by analysts.
- Equity shares are the most common asset class that analysts evaluate. Normally, this includes the equity shares and the preference capital; both of which are residual capital of a company. Preference shares can be either with or without participation and need to be evaluated accordingly.
- Bonds or debentures are normally evaluated by analysts based on the credit profile of the company and its ability to service the principal and the periodic interest from its internal cash flows. This is important as it shows the solvency of the company and has an important bearing on the final equity valuation.
- Derivative analysts are analysts focusing on the futures and options on the stock. Such analysts also look at F&O data in terms of shifts in open interest, shifts in the implied volatility (IV) as well as the shifts in the put call ratio. This is also an analysis of the underlying volatility as much as of the stock in question.
- Technical analysts are a complement to fundamental analysis and help to identify the right levels to enter and exit the stock. Traders rely on technical analysis extensively as they are short term players and do not focus overly on the fundamentals of the company but focus more on underlying trends.
- Analysts also focus on valuation of rights and warrants. These are a right to buy an equity share without an obligation and hence these are valued more as a combination of an equity share and an option.
- Mutual fund analysts focus on the performance and the prospects of equity and debt mutual funds. The focus of the analyst here is more on the contents and the quality of the portfolio of the fund, the Sharpe / Treynor and other risk adjusted return ratios.
- ETF / Index analysts identify the best indices for various index based passive investors. Here the focus is more on identifying the index that best represents the underlying theme of the investor with the lowest level of tracking error.
- Mortgage analyst focus on portfolios of loans that are securitized and sold out as securities. Mortgage analyst focus more on the quality of the loan portfolio, the chances of default and the ability to service the obligations. These are also referred to as pass through securities.
- Primary market analysts give their view on the IPOs / OFS / FPOs that hit the market from time to time. This is slightly more complicated as the amount of information is limited and the reliance is more on the prospectus and the primary meeting with the management of the company.
Qualities of a Good Research Analyst
Evaluation of an analyst is normally a mix of quantitative and qualitative factors. But some broad parameters are as under:
- The analyst must have the ability to understand and interpret the domestic and international macro data and correlate it with the company in question.
- Analysts must be very good with numbers as a lot of valuation boils down to evaluating growth, ratios and then projecting the future trajectory of the company performance. This entails a very sound understanding of tweaking databases, handling calculations and macros with excel spreadsheets, basic programming knowledge etc.
- Domain knowledge is a must for an analyst. This includes deep understanding of the sector or industry being tracked, deep understanding of the strengths and weaknesses of the company, an understanding of market dynamics and valuations etc.
- Analyst is not expected to believe that the management says and they must use their own discretion. Hence, an analyst must be able to look at the company, shorn of all the marketing pitch that the management may present. Focus on the valuation of the company is a must.
- As an extension to the previous point, the analyst must have the ability to probe the management and the channel checks deeper without appearing too intrusive. This is a very important quality for any analyst.
- The job of an analyst calls for an eye for detail. This includes verification of numbers, quality check, language issues, and use of phrases, proper proofing and understanding the report from the customer’s perspective.
- Needless to say, an analyst requires very good communication skills, which is the ability to put across a point effectively and in simple language. They must avoid beating around the bush but make their point very cleanly.
- There are a lot of compliance requirements of an analyst in terms of dealing with a client, dealing with regulator queries, dealing with the press and visual media, use of social media platforms etc. The analyst is required to be aware of all these rules and also adhere to these rules strictly.
The analyst remains the pivotal link between the investor, the company and the stock markets at large. It is a role that must be discharged with skill, finesse, dedication and integrity.