Unless noted otherwise, the word “equity research” in this article refers to sell-side equity research, who produces research reports for institutional equity investors.
For the insiders, if I am missing anything or wrong, please keep me honest.
In a prior article, I argued one should base their offer decision based on the quality of the analyst first. The reason is because research analysts run their teams as portable franchises.
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Yes, investment banks provide the back-end such as office space, payroll, distribution channel, etc., but analysts have 100% discretion on how to run their research team based on their vision.
The franchise nature of the profession explains why asking “which bank has the best equity research report” does not mean much, because the highest ranked internet analyst (Brian Nowak, Morgan Stanley) and the highest ranked large cap biotech analyst (Umer Raffat, Evercore ISI) don't sit in the same firm.
How is the sausage made?
In this section, I am going to show you the whole process in equity research – from content creation to report dissemination. I will use the initiation reports (to be explained later) as an example, but the process is similar for all report notes.
Research Analyst / Team
The research teams are the sources of content. They produce the research reports and create the financial models based on management guidance, macro data and historical financial data of the covered company.
Per FINRA regulation, analysts are not allowed to speak their views on stocks without first publishing reports that contain their views. Therefore, every time analysts join a new firm, they will “initiate” on the stocks they intend to cover (also known as “launching coverage”). The initiation reports are detailed reports that describe the business, competition, products, market size, investment thesis, etc.
Supervisory Analyst (SA)
After the reports and financial models are finished, they are sent to Supervisory Analyst (SAs) for review. SAs are the biggest impediment to report dissemination. So they are disliked by equity research across the industry, but they are a staple feature of the profession.
For example, SAs will check to make sure reports do not solicit investment banking businesses (such as speculating on mergers or acquisitions not confirmed by the press) or do not contain provocative languages (things get subjective quickly and that's when research teams frequently get into shouting matches over email with SAs).
Every single equity research report needs to be approved by an SA before it’s published and disseminated to clients.
Equity Sales & Product Management
After the initiation notes are approved, the analyst will tell Product Management that she will go on the morning call to market the product.
The morning call is a daily meeting that occurs before the stock market open. During the meeting, research analysts who are scheduled to appear will take turns pitching their high-impact research (such as initiation, deep dive, key stock upgrade / downgrades) to equity salespeople, so that the salespeople can promote their research to institutional clients. (For more routine research reports such as earnings notes, analysts don’t go on morning calls.)
During this process, two additional constituents are involved:
- Product Management: They manage the morning call process. They: 1) Decide whom to let on the morning call (because every analyst thinks every research report of theirs is high impact); 2) Provide guidance on best practices for research reports based on client feedback; 3) Keep track of readership metrics; 4) Manage the firm’s annual institutional investor poll process, such as strategy to get more votes and move up the firm ranking.
- Equity Sales: They are the distribution channel. They attend morning call every day because that’s when they receive the products to sell to clients for the first time on that day (if sales know an analyst stock upgrade before the report is published, that's the same as having access to insider information).
- Salespeople have their coverage of client accounts (eg. Hannah covers 5 industrial pods within Millennium Management and a mega single manager hedge fund; while Josh covers technology portfolio managers within Wellington Management, a long only, and a few $200 million AUM long/short hedge funds in Boston).
Some of you might be wondering: If the notes are disseminated to clients’ inboxes directly, why the need for salespeople? The reason: Clients have access to 30+ sell-side firms who all send them research every morning, you think they saw your analyst’s note?
So equity salespeople add value by amplifying the research reports by calling the clients personally: “Hey, Dick Toad put out this amazing deep dive on the flying car industry today. No one on the (Wall) Street has done this depth of work on this space. You should check it out.” That nudge gets client’s attention and drives readership, if the salesperson and the analyst’s pitch is good.
Why does the equity research exist?
A simple industry structure analysis explains well in my opinion: equity research is two-sided aggregation due to highly fragmented nature of its two key constituents: investors and companies (issuers).
Investors: There are tens of thousands of equity investment funds out there. Smaller investment funds can leverage equity research to access management of publicly traded companies of various sizes. Without equity research, these smaller funds would not receive management access because companies prioritize their internal investor relation resources on serving the largest shareholders. This is why research analysts host their own conferences where clients get to do 1-on-1 sessions (for a fee of course) to meet with CEO of companies they are researching.
Companies: Yes, we all know about the S&P 500 companies, but there are many more companies with lower market capitalization who need investor attention. Equity research provides that reach for these companies.
Even S&P 500 constituents wouldn’t mind relying on the sell-side to reach a broader, fragmented group of investors who can be an incremental buyer of their company’s stock. As mentioned before, there is only that much an in-house investor relation department can achieve.
What value does equity research really add?
From the vantage of an outsider (or even those in the industry), a lot of things do not make sense. I think incentives are what made equity research how it is.
Sell-side research is not in the business of generating alpha. Some do differentiate by stock picks. But most add value via other routes that are less stressful than being right on stock picks.
There are analysts within sectors that even the best buysiders respect what they say, but they are the outlier not the norm.
Some of equity research's value add:
- Saves time for buy-siders: financial models, understand the sector, understand the history of a company, understand a business with complex product or business model
- Corporate access: analyst conferences, non-deal roadshows, etc.
- Promote the company (the equity issuer): even most outsiders understand the role research, especially senior analyst, plays in winning IPO deals for her investment bank, so there is no misconception here.
If you are interested in learning more about sell-side equity research, I have two other great articles for you:
Don't know where to start to research and value a company? Have trouble generating stock ideas and differentiating on stock pitch? I can help you. Let's meet!