BEST PRACTICES

Ensuring Every Stock Call Has Value

Avoiding Valuation and Stock-Picking Pitfalls

Getting Others to Act on Stock Recommendations

JAMES J. VALENTINE, CFA

The McGrawHHI Companies

BEST PRACTICES
FOR EQUITY
RESEARCH
ANALYSTS
Essentials for Buy-Side
and Sell-Side Analysts

JAMES J. VALENTINE, CFA

New York Chicago San Francisco Lisbon London

Madrid Mexico City Milan New Delhi San Juan
Seoul Singapore Sydney Toronto
Copyright 2011 by James J. Valentine. All rights reserved. Except as permitted under the United
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publisher.

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To Emma, Laura, A/ice, and Robert for their loving support.
 This page intentionally left blank
If we knew what it was we were doing, it would not be called
research, would it?
Albert Einstein
This page intentionally left blank
 Contents

List of Exhibits xi Preface xvii Acknowledgments xxiii

Introduction 1
Chapter 1. Do You Have What It Takes to Be a Successful Analyst? 9

Mastering Organization and Interpersonal Skills 15

Part 1: Take Control to Optimize the Coverage Universe 17
Chapter 2. Prioritize Time for the Most Valuable Activities 27
Chapter 3. Influence Others to Accumulate Insights and Get Heard 43

Chapter 4. Construct and Organize an Information Hub 51

Buy-Side Only: Maximize Benefits of Sell-Side
Chapter 5. Relationships 67

Chapter 6. Generating Qualitative Insights 77

Identify Factors That Impact a Sector's Valuation and
Part 2: Performance 79

Chapter 7. Identify and Monitor a Stocks Critical Factors 93 Create

Sustainable Proprietary Sources of Insight 119 Get the Most
Chapter 8. from Interviewing for Insights 137
Chapter 9.
Chapter 10.

vii
viii Contents

Part 3:
Generating Quantitative Insights 153
Chapter 11.
Detect Deceptive Numbers 157
Chapter 12.
Leverage Statistics for Insights 163
Chapter 13.
Conduct Surveys to Acquire Unique Insights 185
Chapter 14. Identify Yellow Flags through Forensic Accounting 195
Identify the Relevant Microsoft Excel Features for Equity
Chapter 15. Research Analysts 217
Creating the Best Spreadsheet Architecture for Financial
Chapter 16. Analysis 225
Develop Company Financial Models to Elicit Insights 233
Chapter 17.
Forecast Scenarios for the Most Important Critical Factors
245
Chapter 18.
Mastering Practical Valuation and Stock- Picking Skills
255
Part 4: Understand the Benefits and Limitations of Common
Valuation Methodologies 257
Chapter 19. Overcome Challenges to Creating Discerning Stock Calls
271
Chapter 20. Avoid Common Psychological Challenges That Impede
Sound Investing 305
Chapter 21. Leverage Technical Analysis to Improve Fundamental
Analysis 325
Chapter 22. Communicating Stock Ideas So Others Take Action 341
Chapter 23. Create Content That Has Value 343
Part 5:
 Contents ix

Chapter 24. Identify the Optimal Communication Channels 351

Chapter 25. Convey the 7 Critical Elements of Stock Recommendations
357
Chapter 26. Special Considerations for the Most Important Delivery
Channels 371

Part 6: Making Ethical Decisions 389

Chapter 27. Identify and Resolve Ethical Challenges 391

Works Cited 403

Index 407
This page intentionally left blank
 List of Exhibits

Exhibit 1.1: Primary Tasks of an Equity Research Analyst 4 Best

Exhibit 2.1: Practice (Skills): Take Control to Optimize the Coverage
Universe 24 Time Allocation for Buy-Side and Sell-Side
Exhibit 3.1: Analysts 29
Automate, Delegate, or Outsource Decision Tree 34
Exhibit 3.2: Best Practice (Knowledge): Time Parameters for
Exhibit 3.3: Conversations and Meetings 35
Best Practice (Skills): Time Management Tips for
Equity Research Analysts 40
Exhibit 3.4: Best Practice (Knowledge): Understand the Key
Skills Required for Influencing Others 50
Exhibit 4.1: Best Practice (Knowledge): Key Information to
Collect 52
Exhibit 5.1: Pros and Cons to Notetaking Options 63 Best Practice
(Skills): Construct and Organize an Information Hub 65
Exhibit 5.2:
Best Practice (Skills): Buy-Side OnlyScreening Sell-Side
Exhibit 5.3: Research 72
Sell-Side Skills and Knowledge as Prioritized by Buy-Side
Exhibit 6.1: Clients 74
Best Practice (Skills): Maximize Benefits of Sell-Side
Exhibit 6.2: Relationships 75

Exhibit 6.3:

Exhibit 7.1: Food Chain Analysis for U.S. Railroad Sector 89

xi
xii List of Exhibits

Exhibit 7.2: Best Practice (Skills): Identify Factors That Impact a

Sectors Valuation and Performance 91
Exhibit 8.1: Forward-Looking Relative P/E Ratios for Major
Railroads Operating in the United States (relative to the
S&P 500) 99
Exhibit 8.2: Best Practice (Knowledge): Questions to Investigate
before or during Interviews with Management 107
Exhibit 8.3: Best Practice (Knowledge): Documents to Review before
Interviewing Management 109
Exhibit 8.4: Best Practice (Skills): Flow Chart of Ongoing Activity for
Identifying a Critical Factor 113
Exhibit 8.5: Best Practice (Skills): Identify and Monitor a Stock s
Critical Factors 116
Exhibit 9.1: Best Practice (Knowledge): Time and Cost for
Information Sources (ranked from lowest to highest
based on typical cost) 124
Exhibit 9.2: Best Practice (Skills): Assessing and Approaching
Information Contacts 129
Exhibit 9.3: Best Practice (Skills): Keeping the Right Distance with
Company Management 131
Exhibit 9.4: Best Practice (Skills): Network within Your Firm 136
Exhibit Best Practice (Skills): Create Interview Questions That
10.1: Will Get Answers 139
Best Practice (Skills): Lead an Interview to Obtain
Exhibit 10.2: Insights 141
Best Practice (Knowledge): Observing Body Language to
Exhibit 10.3: Detect Deception 145
Best Practice (Knowledge): Spotting the Top 10
Deceptions When Presented with Data 157
Exhibit 11.1:
Best Practice (Knowledge): Considerations When
Exhibit 12.1: Comparing Data Series 165
 List of Exhibits 13

Exhibit 12.2:
Exhibit 12.3:
Scatterplot with No Association 169 Scatterplots Where
Exhibit 12.4:
Association Exists 170 Quarterly Intermodal Revenue
Exhibit 12.5:
171 Examples of Scatterplots 173
Exhibit 12.6: Scatterplot and Regression Line for Intermodal Revenue
and Manufacturing Index 174
Exhibit 12.7: Regression Output for Log of Durable Manufacturing
and the Log of Intermodal Revenues 175
Exhibit 12.8: Scatterplot and Regression Line for Log Intermodal
Revenue and Log Manufacturing Index 176
Exhibit 12.9: Residuals from Regression 178
Exhibit Regression Output for Lagged Values of the Log of
Durable Manufacturing and the Log of Intermodal
12.10:
Revenues 179
Residuals from Regression 179
Exhibit 12.11: Output for Freight Revenue versus Expense Line Items
Exhibit 12.12: 181
Best Practice (Skills): Use Regression Analysis to Improve
Exhibit 12.13: Forecasting 183
Example Cover Page for Online Survey 191
Best Practice (Skills): Conduct Surveys to Acquire Unique
Exhibit 13.1:
Insights 192
Exhibit 13.2: Best Practice (Skills): Spotting Accounting Yellow Flags
214
Exhibit 14.1: Best Practice (Knowledge): Relevant Excel Features for
Equity Research Analysts 219
Exhibit 15.1: Best Practice (Knowledge): Useful Excel Keyboard
Shortcuts 223
Exhibit 15.2: Best Practice (Knowledge): Most Relevant Excel
Functions and Formulas for Equity Research Analysts
224

Exhibit 15.3:
14 List of Exhibits
Exhibit 16.1:
Best Practice (Skills): Creating the Best Spreadsheet
Architecture for Financial Analysis 226
Exhibit 17.1:
Best Practice (Knowledge): Elements of a Good
Company Model 235
Exhibit 17.2: Sources for Company Financial Models 237
Exhibit 17.3: Modeling Considerations Unique for Value versus
Growth Companies 239
Exhibit 17.4: Best Practice (Skills): Develop Company Financial Models
to Elicit Insights 241
Best Practice (Skills): Creating Forecast Scenarios in Excel
Exhibit 18.1:
251
Best Practice (Knowledge): Benefits and Limitations to
Exhibit 19.1:
the Most Common Valuation Methodologies 265
Best Practice (Skills): Rigorously Develop an Appropriate
Exhibit 19.2: Valuation Multiple 267
Best Practice (Skills): Exploit Flaws in Market Sentiment
Exhibit 20.1: to Enhance Stock Picking 282
Best Practice (Knowledge): Factors to Monitor to
Exhibit 20.2: Understand Market Sentiment 283
Best Practice (Skills): Build a Comp Page to Identify
Stocks with the Most Upside and Valuation Outliers 295
Exhibit 20.3:
Best Practice (Knowledge): Appreciate Lessons Learned
from Experienced Stock Pickers 298
Best Practice (Knowledge and Skills): Ensuring Success as
Exhibit 20.4:
a Stock Picker 301
Investor Personalities 307
Exhibit 20.5: Best Practice (Knowledge): Most Common Psychological
Pitfalls of Investment Professionals 318
Exhibit 21.1:
Exhibit 21.2:

Exhibit 22.1: Explanation of Candlestick Chart 327

 List of Exhibits XV

Exhibit 22.2:
Example of Candlestick Daily Price Chart over 12 Months
Exhibit 22.3: 328
Example of Candlestick Monthly Price Chart over 30
Exhibit 22.4: Years 330
Example of Candlestick Weekly Price Chart over 10 Years
Exhibit 22.5: 331
Exhibit 22.6: AAPLs Daily Price Chart with Volume Showing Support
and Uptrend 332
Exhibit 22.7:
Daily Price Chart with Momentum Oscillator 336
Exhibit 23.1: Best Practice (Skills): Blend Technical Analysis with
Fundamental Analysis 338
Best Practice (Knowledge): Ensure Content Has Value
Exhibit 24.1:
Using the ENTER Framework 345
Communication Channel Trade-Offs When Presenting
Exhibit 24.2:
Stock Ideas 352
Best Practice (Knowledge): Delivery Channel Pros and
Exhibit 25.1:
Cons for Communicating Stock Ideas 353
Best Practice (Knowledge): Ensure That the
Message Has Value Using the CASCADE
Exhibit 25.2:
Framework 358
Best Practice (Knowledge): Terms and Phrases Used by
Exhibit 26.1:
Practitioners 369
Best Practice (Knowledge): Specific Tips for Presenting to
Exhibit 26.2:
Others 373
Best Practice (Skills): Specific Tips for Creating
Exhibit 26.3: PowerPoint Presentations 374

Best Practice (Skills): Specific Tips for Marketing

Exhibit 26.4: Handouts 376
Best Practice (Skills): Specific Tips for Leaving Voicemails
377
xvi List of Exhibits

Exhibit 26.5:

Best Practice (Skills): Specific Tips for E-mails and Text

Exhibit 26.6:
Messages 380
Exhibit 26.7: Value of Report Qualities 382 Value
Exhibit 26.8: of Report Components 383
Best Practice (Knowledge): Special Considerations for
Exhibit 27.1: Writing Research Reports 384
Best Practice (Skills): Follow Ethical Practices to Make the
Right Decisions 400
 Preface

I thoroughly enjoyed my career on Wall Street. I couldnt have asked for

more thoughtful clients, talented team members, or supportive research
management. But during those 16 years, I became intrigued by the criticism
surrounding the quality of equity research, often coming from within the
industry. There was no shortage of intelligent, hard-working individuals. So
why wasnt there an abundance of world- class research? Im not sure that I
solved the entire mystery, but I did reach one major conclusion: There are
few, if any, quality control processes. Furthermore, there is minimal
professional training provided to equity research analysts.
Think about it: An experienced portfolio manager is relying on internal
buy-side and external sell-side analysts to provide accurate, insightful
information to make decisions that can impact millions, and possibly
billions, of dollars of return over the life of an investment. And yet most of
these analysts never received professional training beyond what they picked
up on the job and classes they may have taken in college. Instead, our
profession relies on the medieval master-apprentice approach, which results
in training only as good as the master. Our society doesnt allow this in the
medical, legal, or accounting professions, or even for licensed plumbers or
electricians. Those fields require that certain best practices be learned, and
that mastery be validated by a certification process. The closest thing we
have is the CFA certification, which is highly credible, but not required for
the profession. (Only a fraction of equity analysts are CFAs.)
So how bad is it? Let me first say, Ive met more talented buy-side and
sell-side analysts than I can countindividuals who produce impressive
alpha-generating research. But unfortunately, this has been

17
xviii Preface

the exception more than the rule. As an analyst who worked at four of
the largest sell-side firms in the United States, I witnessed too many
inexperienced analysts making poorly constructed stock calls, often based
on unsubstantiated theses (including me, during the first few years of my
career). Worse yet, often in instances where the sell-side analysts produced
good research, they couldnt effectively manage their franchise to get
recognized by clients.
I didnt sense it was substantially better on the buy-side. Based on the
100 to 150 conversations I had with mv clients everv month, it was clear
that there were too many buy-siders struggling in their roles, specifically
failing to identify the factors most likely to drive their stocks. Occasionally,
when I would get off the phone with a buy-side professional discussing a
stock his or her fund owned, Id wonder how the person could fail to
understand some of the more basic elements of the story. To illustrate my
point, here are some real-world comments I heard during my career:

I dont want to touch that stock because Im concerned about a

labor strike (even though the company was non-union and would
benefit from a strike at its unionized competitor).
We sold the [transportation] stock because oil prices are likely to
rise (even though this companys adjustable fuel surcharge was so
lucrative that margins expanded when fuel prices rose).
Im recommending this stock because were bullish on ethanol
(even though ethanol was less than 1 percent of the companys
revenue, and under an ultra-bullish scenario would go to no more
than 3 percent of revenue over five years).

If these individuals were investing their own money, I could easily accept
their misunderstanding of the companys fundamentals. But it was other
people's moneypeople who were entrusting them to fully understand the
investment case for a stock, which clearly wasnt happening. A buy-side
analyst, with more than 10 years of experience at a firm managing over $ 100
billion in assets highlighted the impact this has had more recently, when he
said, "Wall Street is shrinking because a generation of investors are alienated
 Preface xix

with equities. To help remedy the credibility problems he believes,

"Anyone who wants to be successful in this business needs to follow best
practices. (His thought was an inspiration for the book title.)
In 2006, after having been a sell-side analyst for 14 years, I decided to do
my part to help improve the industry's quality issues by taking on a newly
created role to develop a global training program for the one thousand
employees in my firm's equity research department. Based on my
experience as an analyst and holding this role, I began to formulate best
practices for equity research analysts, which I later refined further through
interviews with practitioners from other sell- side and buy-side firms.
There may be seasoned practitioners who consider my recommendation
that analysts strive to follow these best practices as too ambitious,
remarking, "There's no way an analyst could do all this. I agree; for many
practicing analysts, such as those on the buy-side who are asked to closely
follow well over 50 stocks with no support (or over 20 on the sell-side), it
will be a challenge to implement many of the best practices, for sheer lack of
time. These individuals are attempting to put out a high-rise fire with a
garden hose. If there is cynicism about implementing best practices, Id
question if it's coming from the same population that underperforms the
market each year. The industry has massive performance issues, and nobody
seems to know how: to fix them. (According to Standard & Poor's most
recent data, 60 percent of U.S. equity funds underperformed their
benchmarks over the past five years, which drops to a still disappointing 56
percent over the past three- and one-year periods.) I have one remedy:
Reduce the amount of stocks an analyst covers. I'm not diminishing the
need for generalist analysts, but let's call them what they are: portfolio
managers or assistant portfolio managers. The best practices found here will
likely help any type of equity analyst, but many are designed for those who
look at their stocks from a bottom-up perspective and, most importantly,
dont cover an excessive number of stocks.
If youre not sure how to prioritize the material that follows, new ana-
lysts should first focus on Part 1 because the topics are central to everything
an analyst does. Experienced analysts can potentially jump to some of the
xx Preface

most pressing challenges they face by focusing on (1) identifying and

monitoring critical factors (Chapter 8), (2) forecasting scenarios (Chapter
18) and (3) improving their stock calls (Chapter 20 and 21). Alternatively,
first read all of the books exhibits labeled Best Practice and then go back
to the chapters where you have the greatest interest.
The material attempts to solve problems that are typical for buy- side and
sell-side roles, and drills dow n with more detail when its clear a solution for
the buv-side role is different than for the sell-side. Its important to note
that all of the best practices were used by one or more of the practitioners
interviewed for the book or by my team during my career. Ive provided the
practitioners names when referring to their quotes throughout the book,
but unfortunately a number are restricted by their firms from being
identified for attribution. (Morgan Stanley allowed its analysts to be quoted,
which explains why they appear more featured than other firms throughout
the book.) Some of the best practices may appear ambitious to implement,
but others have done it. Be mindful of the adage, You dont achieve goals
you dont set.
This book wasnt written simply to help analysts improve, but also to
give them the competitive advantage to move to the top 10 percent of their
peers. This isnt a textbook; the intent is not to repeat concepts already
learned in college, but to provide whats required to get the job done
successfully for buy-side and sell-side practitioners. When I set out to create
these best practices, the goal was to get as much concentrated material into
one place as possible, but space constraints prohibit in-depth discussions in
many topics. The goal was to identify the skills and the body of know ledge
required for success, but its unrealistic to think that everything an analyst
will ever need to know will be in one book, especially for complex subjects
such as accounting, statistics, valuation, and technical analysis. Hopefully,
after reviewing these best practices an analyst will at least know what he or
she doesnt know. From there, the challenge will be to become proficient in
those skills or gain greater knowledge. The best-practice exhibits are
intended to be stand-alone tools that an analyst can quickly review to help
master that task, and thus the content in the exhibits is often found
 Preface xxi

elsewhere in the text. Due to space limitations, supplemental information

can be found at AnalystSolutions.com. Furthermore, I encourage you to
visit www.AnalystSolutions.com/book to provide your best practices or
additional input to make these best practices better. Its my expectation that
this body of knowledge will evolve as more practitioners contribute their
best practices.
When I was an analyst, I was a big believer in being transparent to my
clients so they could see my potential biases. In this spirit, its important to
disclose that during the writing of this book I havent received
compensation from any of the companies or vendors mentioned in this
book, other than the use of FactSets database to compile data for the book
(to whom Im thankful) and a diminutive dividend from unvested Morgan
Stanley stock I dont yet control (awarded as compensation when I was an
employee).
I cant think of a better job than the role of an equity research analyst. If
you do your job well, youre essentially your own boss, deciding how to
spend your time, with almost full control over your career success. Theres
frequent interaction with some of the sharpest people youll ever meet. No
two days are ever the same. And if you like to travel, theres often no
limitation on the number of places youll see. Oh, and did I mention the pay
isnt too bad? To anyone who complains about the profession, including
those who say its no longer fun after Regulation FD and the Spitzer
Settlement, I challenge them to find a more rewarding career. Hopefully, the
material that follows will help make this career just a bit more rewarding.
This page intentionally left blank
 Acknowledgments

I d like to start by thanking those friends and colleagues who spent

considerable time helping draft and edit portions of the manuscript,
including Lauren Bloom, Chad Bruso, Dorris Dolph, Hunter DuBose,
Chris Gowlland, Elmer Huh, Bob Jones, Barbara Lougee, Kurt Moeller,
Quentin Ostrowski, Judy Sheehan, Barn* Sine, Emma Valentine, and Chris
Wright.
I would also like to thank all of the friends and colleagues who helped
provide insight for the book as well as those who had a significant influence
in shaping my view of the profession and many of the best practices in this
book: David Adelman, Ajit Agrawal, Christine Arnold, Reena Bajwa, Jay
Bennett, Rich Bilotti, Michael Blumstein, Bob Brizzolara, Celeste Brown,
Nathan Brown, Zach Brown, Jeff Burton, Mayree Clark, Doug Cohen, Jim
Crandell, James Crawshaw, Christina Dacauaziliqua, Darius Dale, David
Decker, Ridham Desai, Christian Drake, Michael Eastwood, Jason
Eiswerth, Robert Fagin, Simon Flannery, Casey Flavin, Phil Friedman,
Steve Galbraith, Steve Girsky, John Godyn, Ron* Green, Bill Greene,
Michael Griffiths, Gem Guiang, Ian Gutterman, Phil Hadley, Nick Harness,
Trevor Harris, Tony Hatch, John Havens, Shora Haydari, Matt Hedrick,
Alison Henry, Marvin Hill, Allison Hirsch, Dickson Ho, Barry Hure- witz,
Vlad Jenkins, Drew Jones, Rupert Jones, Hani Kablawi, Jane Kamneva, Jeff
Kanter, Ronny Kaplan, Allison Kaptur, Ed Keller, Evan Kurtz, Michelle
Leder, David Lee, Chris Leshock, Mark Liinamaa, Steve Lipmann, Dario
Lizzano, Adam Longson, Steve Madonna, Mike Manelli, J. P. Mark, Gerson
Martinez, Mike Mayhew, Brian McGough, Mary Meeker, Greg Melich, Ron
Monaco, Suzanne Morsfield, Jack Mueller, Todd Neel, Peter Nesvold, Matt
Nielsen,

xxiii