Introduction
Equity Research of listed stocks forms a major part of operations in Hedge Funds, Investment Banks, and many Asset Management firms.
Though methods may differ, all the exercises related to equity research mostly pertain to finding the intrinsic value of the stock and then inferring if it’s overvalued or undervalued currently, prompting buy sell or hold recommendations for the asset managers or their clients.
What makes an equity research exercise comprehensive?
Though equity research exercise could potentially be a theoretical exercise where an Equity Research analyst puts in a few hours’ of efforts, crunch numbers, and comes up with a recommendation. These models are almost always prepared and just need P&L, Balance Sheet, and Cashflow numbers, which are available in the public domain for a listed stock, fed in, to find out the valuation and the recommendation for the stock.
It is however the further details that determine the quality of the research. These are a variety of sources, qualitative inputs and their quantification, Evaluation of the ongoing news and buzz related to the stock, social media activity, rumors, and the subjective calls of analyst that makes the difference. It’s amazing that some analysts even track the brand of the watch that the CEO wears to the analyst conferences. They make subjective calls on the stock on an information point as minute as that or say body language of the management in a conference call.
If a stock is to watched as closely as needed to take calls worth millions, it’s not possible for an equity research analyst to proceed in a templated way for all the stocks she needs to track. It needs to go much beyond that.
Parts of a comprehensive Equity Research exercise
Here is what differentiates a comprehensive analysis from a basic one
Sources of Information: Sources of information if more the merrier. Sources of information if diverse allows us to analyze the stock closely. For example, a database that carries information about all the legal cases pending against a company would add color to the analysis that will have a material impact on the overall recommendation for the stock. Usual sources of information are P&L, Balance sheet, and cash flow statements, all of which are publicly available for a listed stock apart from news about the stock, regulatory filings, 10Ks, conference calls, and ESG related compliance documents.
Forecast and Assumptions: A financial forecast can easily be put together sometimes by just extrapolating the past growth in the future. That is a simplistic but not correct way of doing it. The heart of a financial or earnings forecast is the assumptions made to arrive at the same. All assumptions need to be reasonable and preferably vetted by industry experts. Companies may be bullish about their latest strategy and its financial impact, but that needs to be looked at cautiously if at all it is going to lead to any impact, and if yes, how much. That is where industry studies come into play. A company forecast needs to be compared with industry forecasts and if the company’s growth forecasts are more than that of the industry, has there been any past instances when the company had beaten the industry forecasts. For example, if a healthcare company is planning to launch equipment that will take a leadership position in five years, has there been any past instance for this healthcare company to take a leadership position within five years of the launch in the past? The key to a robust model is going into detail about all the assumptions and making sure all assumptions are validated by past numbers.
Company Valuation Analysis
Equity Quantitative Research methods aim at valuing the company using more than one method to see if all valuations are consistent with each other. If there is a huge variation in valuations of companies by different methods, the analyst needs to arrive at the best suitable valuation with sound reasoning. The most common equity research models to find out the valuation of a company are DCF modeling, Relative Valuation, Sum of Parts, and Risk Assessment. DCF that stands for Discounted Cash Flow analyzes all the future cash flows of the company and discounts it to the present value. Relative Valuation compares the company valuation with peers to see if it is relatively undervalued or overvalued. The Sum of parts breaks a big company into smaller chunks and finds if the sum of all parts of valuations of a company is equal to the overall company valuation. The risk assessment identifies all the risks and quantifies the material impact of risks into the valuation
Qualitative Assessment
Numbers do tell the story but miss while indicating the future, which is unknown. That is where the qualitative inputs come into play. An experienced analyst can convert these qualitative inputs into quantitative ones that impact the valuation. Some of these qualitative inputs are quality of management, Competitive intensity in the industry, ESG initiatives and risks, and analyzing Porter’s 5 forces. It’s to be noted that Porter’s 5 forces is a highly qualitative model and needs to be put on a quantification scale.
Different institutions approach equity research differently depending on their business and operational needs. Here is how Equity Research differs across institutions
Equity Research for Investment Banks
Equity Research at Investment Banks is as much as a Marketing exercise as it is operational. Usually, an Investment Bank would send stock recommendations to all its current and potential clients. These recommendations are sometimes not detailed as the detailed research is kept for high paying clients. An equity research report is prepared for every stock. The report is templated and carry similar content for all the stocks that the bank tracks. It also suggests the buy, sell, or hold recommendations along with the price range to expect for each stock. Detailed equity research is also done for the buy-side. There are multiple research report templates that are available with an Investment Bank.
Earlier the research cost was added to the brokerage cost for an investment bank. Now a regulatory notification in Europe bars Investment Banks from clubbing brokerage and research costs together. This means now research needs to be high quality and needs to be provided only when the client demands. It’s just a matter of time that these regulations catch hold in the United States and other financial markets across the world.
Equity Research for Hedge Funds
Equity Research for hedge funds is done towards the aim of portfolio management and taking long and short positions regarding listed stocks
Hedge Funds are quite secretive about the methodology they follow while picking up stocks. Sometimes the secrecy is warranted as they have something that is really unique but most of the time it’s just a marketing gimmick to avoid further questioning about their methodology. Many claim to use Machine Learning and Artificial Intelligence to pick up the stocks. Equity Research in Hedge Fund parlance is the most critical part of Operations. There is also a huge reliance on Technology with trades mostly intraday and sometimes in milliseconds!! But there is nothing that has replaced the good old fundamental analysis.
Hedge Funds also specialize in technical analysis apart from fundamental analysis. Technical analysis uses mathematical formulas to project trends and thus the future stock price for short term trades.
Equity Research for Private Equity
Private Equity usually deals in Private stocks but sometimes they do pick up stake in listed companies as well. Equity Research in Private Equity is very different than what is done in Hedge Funds and Investment Banks. It is because mostly Private Equity is interested in buying a significant stake and thus has far more information and management bandwidth at its disposal. It uses that leverage to get and analyze information that is usually not available in the public domain.
Equity Research for Asset Managers
All other forms of Equity Research vary in complexity and methodology but mostly sticking to finding the intrinsic value of the stock with the aim of finding undervalued stocks for investments. Some Asset Managers specifically perform equity research for retail investors.
Magistral’s Approach for Equity Research
Magistral is an equity research firm that focuses on Fundamental Research to find out the intrinsic value of a stock using multiple sources. Our methodology takes into account multiple sources to start with and those sources are continually refreshed to update the model to carry the latest intelligence. We also prepare customized Equity Research report. Here is how our Equity Research Process looks like
Magistral’s Equity Research Methodology
Our equity research services are customizable and scalable as per clients’ requirements. Magistral has delivered multiple Equity Research projects in the past
About Magistral
Magistral Consulting has helped multiple funds and companies in outsourcing operations activities. It has service offerings for Private Equity, Venture Capital, Family Offices, Investment Banks, Asset Managers, Hedge Funds, Financial Consultants, Real Estate, REITs, RE funds, Corporates and Portfolio companies. Its functional expertise is around Deal origination, Deal Execution, Due Diligence, Financial Modeling, Portfolio Management and Equity Research
For setting up an appointment with a Magistral representative visit www.magistralconsulting.com/contact
About the Author
The Author, Prabhash Choudhary is the CEO of Magistral Consulting and can be reached at Prabhash.choudhary@magistralconsutling.com for any queries or business inquiries.