Zen & The Art of Investment Research

I suspect that most people find research intensely boring. I further suspect most people find research boring because it is often done backwards. Frequently in business upper management has decided on the plan and an analyst’s job is to support the boss’s plan with data. If you work for a policy think tank, for instance, you know all your conclusions in advance.

The main problem with research in The Real World is that someone has to pay for it to be produced, and this almost invariably creates conflicts of interest that diminish the objectivity and thus quality of the research product.

On Planet Finance, for example, we refer to “sell side” and “buy side” research. Both the sell side and the buy side produce investment research. To the layperson the research products are indistinguishable. To the practitioner they can be worlds apart.

Buy side research is produced by individuals responsible for managing client money. For example, a financial advisor may research a stock for a client portfolio. The advisor is incentivized to do thorough research (note: this is not the same as saying the advisor actually conducts thorough research). If the advisor buys the stock for her client and it goes to $0 the client will likely fire her.

Things are more complicated for the sell side. The sell side makes money “selling” investment research to people like financial advisors. However, a tremendous volume of sell side research is produced by research groups at large banks. These banks generate significant fee revenue via their investment banking activities (e.g. helping companies issue stock on the public markets). You see the conflict. If Company A has a significant investment banking relationship with Bank B, how likely is Company A to maintain that relationship if Bank B Research slaps it with a Sell rating?

Not very likely.

Don’t take my word for it. Look at some raw data. A 2015 analysis by Bespoke Investment Group found that of 12,122 ratings on US companies, only 6.67% were rated “Sell.” 48.4% were rated “Buy” and 44.9% were rated “Hold.” On Wall Street, “Hold” is often regarded as analyst code for “Sell.”

Some people will argue there are compliance procedures like departmental firewalls to prevent conflicts of interest from influencing analysts’ recommendations. To which I would respond with The Golden Rule: He Who Hath The Gold, Maketh The Rules.

You may quote me chapter and verse from a compliance manual. I do not care what is written in someone’s compliance manual. In practice, if ever there is a dispute between a profit center like an investment banking group and a much smaller profit center (or, god forbid, a cost center) like a research group the profit center will win out every time.

Examining applications of The Golden Rule throughout history and contemporary events is part of what this blog will be about. This blog will also be about exploring the way the world works, through the lens of The Golden Rule, without needing to worry about where we end up and whether our conclusions might cost us our jobs.

One of the things that drew me to investment research is that in its purest form, it provides clears incentives, both positive and negative, for intellectual honesty, regardless of whether something makes you uncomfortable ideologically. Hedge fund manager and prolific blogger John Hempton puts it thusly:

“Money management can be one of the most interesting careers in the world. At best it gives you lots of unstructured time to think about how the world really operates – and to make bets based on your hypotheses. You get to conduct uncontrolled but real time experiments in the social sciences. But never forget this is a social science – not physics – and a little dogmatism about your rules or positions can result in getting it spectacularly wrong.”

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