On Sell Side Research...

Over the weekend, in response to my post regarding the CSFB's Special Situation Conference, a reader sent me this lovely sentiment (my redaction):

I think this conference should be renamed the "annual clear our ****** inventory conference"

In Security Analysis, Ben Graham wrote this:

Advice from Investment Banking Houses: There are objections of another kind to the advisory service of an investment banking house. An institution with securities of its own to sell cannot be looked to for entirely impartial guidance. However ethical it aims may be, the compelling force of self-interest is bound to affect its judgement. This is particularly true when the advice is supplied by a bonds salesman whose livelihood depends on persuading his customers to buy the securities that his firm has "on its shelves."

Do not get me wrong: Some of the best business analysts and close friends of mine work on both the dealer and broker side as desk or publishing analysts. A number of them have made legendary calls and pointed me to situations that I wouldn't have taken a second look at if it were not for his / her recommendation.

But investment banks and brokerages make money off of trading. If a hedge fund has a large block of 30-50M bonds that they would like to sell through a broker, I can pretty much guarantee you that that broker will be putting out some piece of literature at the very least advocating some of the benefits of the investment. On the dealer side, research analysts sometimes have functioned as the analyst for the prop book which leads to a whole other series of conflicts.

With that said, a buyer of a security needs to ask himself "Why is the seller selling?" If its for uneconomic reasons, the buyer, in theory, should have an advantage in the situation. But if it is not, a buyer needs to tread carefully as a seller has probably held the position significantly longer than you have researched it and therefore has a sort of informational advantage. Of course, this informational advantage could tilted to erroneous opinions or biased by behavioral finance concepts discussed in the past. Which is all the better for the buyer.

When I am researching a situation, this is a typical sequence of events:

1. Read all Ks, Qs, 8ks, proxies
2. Read all transcripts from quarterly reports, events, etc
3. Read news items about specific company and competitors going back the past year +
4. Talk to competitors, people in the supply chain, former employees, etc
5. Determine a reasonable set of assumptions for business and the associated value of the business. Write these numbers down before proceeding to step 6.
6. Talk to the sell side/ read sell side reports to see if the "market" assumptions are dramatically different than my own
7. Buy / Sell

Of course, this is somewhat simplified, and I can't give away all my tricks, but the reader gets the point. In no way, shape or form, am I using a sell side recommendation of overweight, underweight, buy, sell, etc in my purchase decision. Instead, I am using the sell side to provide the market sentiment on a particular name which is inclusive of concerns the larger investment community might have for a situation, assumptions for growth going forward, opinions on future capital allocation decisions, etc.

There will be disparity in these numbers. In the Nortel case, before they sold the IP to the consortium, you could read 6-8 different reports with values ranging from the stalking horse bid of $800M to $3 billion. That is the market assumption. If it comes in at the high end of that range, you'll do ok. If you it comes in the low end of the range, you'll probably lose some money. But if you did your work and came up with a number closer to the actual purchase price, you had a winner.

Julian Robertson used to invite two sell side analysts to Tiger Management to come in and talk about the same situation at the same time. One of these analysts would be a bull, and the other bear. Julian would sit back and listen to the prevailing argument and soak up tons of information on not just the underlying businesses, but also what the positive and negative scenarios were. Every time you look to purchase a security, you should have the intellectual integrity to say to yourself "How could I be wrong...what is the bear case here?" Charlie Munger is famous for recommending the simple, but rarely implemented advice of, "Always invert."

Under the "Always Invert" doctrine, what makes a great sell side analyst?

• Instead of conflicts, he/she would always be independent
• Instead of opinions, he/she would provide the most salient, unearthed facts that no one else was talking about
• Instead of hugging the consensus or guidance, he/she would step out and make a call that was bold and unique
• Instead of pitching the same ideas investors hear every day, he/she would present unique situations to investors
• Etc Etc

Some analysts already do this, and these are the ones that will most receive my business. If you have any thoughts on the great analysts out there (on the high yield / distressed desk & publishing side), would love to hear them (hunter [at] distressed-debt-investing.com)