Here, there are several distinctions between types of research—breaking it down by style, capital structure and firm. While the main focus will be on fundamental equity and fixed income research, it will also discuss the other types of research as well as the functional roles analysts play at different types of firms.
1. Research Styles
Fundamental research takes a deep dive into a company’s financial statement as well as industry trends in order to extrapolate buy and sell investment decisions. There is no clear cut way in conducting fundamental research but it normally includes building detailed financial models, which project items such as revenue, earnings, cash flows and debt balances. Some asset managers may focus solely on earnings growth while others may focus on returns on invested capital (ROIC). It is important for the candidate to understand the firm’s investment philosophy. This can usually be achieved by doing research on the company’s web site. It is important to note that while some firms have clear cut investment philosophies, others may not. Aside from building a financial model, the fundamental research analyst will talk to company management as well as sell-side analysts, and visit company facilities in order to get a complete perspective of the potential investment. Again, the way analysts go about this often differs. Some researchers feel comfortable with only the resources at their desk—their computer, internet, and phone—while others refuse to make investment decisions without face-to-face management meetings and visiting manufacturing facilities (which is often referred to as “kicking the tires”).
Quantitative research is built on algorithms and models, which seek to extrapolate value from various market discrepancies or inefficiencies. The key difference between fundamental and quantitative research is where the analyst puts in the work. The majority of work for a quantitative analyst rests within choosing the parameters, inputs, and screens for the computer generated model. These models can take on a multitude of forms. For example, a simple model that seeks to take advantage of price discrepancies in the S&P 500 may split the 500 stocks between those that are “undervalued” as determined by a low price-to-book multiple from those that are “overvalued” as determined by a high price-to-book multiple. The quantitative analyst would build a model that would screen for these parameters and would buy (or go long) the undervalued stocks while simultaneously sell (or short) the overvalued stocks. In reality, quantitative models are much more complex than the example provided and often screen for thousands of securities across a multitude of exchanges. It is not a surprise to learn that the “brains” behind these models often have PhDs in fields such as finance and physics.
Technical research or analysis is the practice of using charts and technical indicators to predict future prices. Technical indicators include price, volume and moving averages. Technical analysts are sometimes known as “chartists” because they study the patterns in technical indicator charts in order to extrapolate future price movements. Over time, technical analysts try to identify patterns and discrepancies in these charts and use that knowledge to place trades. While fundamental analysts believe that the underlying fundamentals (revenue, earnings, cash flow) of a company can predict future stock prices, technical analysts believe that technical indicators can predict future stock prices. The skill set for technical research is very different than fundamental research. Some technical analysts rely solely on their eyes to spot trading opportunities while others use complex mathematical indicators to identify market imbalances.
2. Capital Structure: Equity vs. Fixed Income
Across the buy-side and sell-side, fundamental analysts often focus on either equities or fixed income (debt). What are the differences between a fundamental equity and fixed income investor? The differences primarily lie within the fundamental financial analysis and breadth of coverage.
Fundamental financial analysis:
Fundamentals affect equity prices and bond prices in similar fashions. If a company is generating strong revenue and earnings growth, improving its balance sheet, and is gaining market share in its industry, both its stock and bond prices will likely increase over time. Most equity analysts and stock investors are focused on net income per share or earnings per share (EPS), as this represents the amount a company earns and is available per share of common stock. Another factor that equity investors are concerned about is how management deploys its excess cash. Analysts are constantly looking for earnings accretion, or the ability to increase earnings per share. If company management uses excess cash to make a smart acquisition or repurchase its own stock, equity investors are generally pleased as the transaction increases EPS.
For fixed income analysts and bond investors, the emphasis is not necessarily on earnings but more so on “earnings before interest and taxes” or EBIT. Bond holders are primarily focused with receiving interest payments and the return of principal. Therefore, they often only follow the income statement up until the point where interest is paid. Another key focus for fixed income investors is the amount of debt (or leverage) a company has on its balance sheet. Since debt holders have claims on a firm’s assets, the more debt there is, the less of a claim each debt holder may have on a given amount of assets.
Fixed income analysts and investors are often focused on two metrics—the leverage ratio (debt/EBITDA) and interest coverage ratio (EBITDA/interest expense). EBITDA stands for earnings before interest taxes depreciation and amortization, and is generally used as a proxy for cash flow. Fixed income analysts like a decreasing leverage ratio as it signifies less debt on the balance sheet and a greater ability to repay it, and an increasing interest coverage ratio as it signifies the greater ability to service the outstanding debt.
Breadth of coverage:
Breadth of coverage refers to the amount of companies and securities an analyst covers. Most companies usually issue only one type of equity security but could have several pieces of debt outstanding. The fixed income analyst usually would cover all of these debt instruments, which may each have separate and distinct provisions that could alter their individual performances.
Additionally, a company may have convertible bonds, which the fixed income analyst would typically cover.
Sell-side equity analysts typically cover between 15 and 20 stocks and are expected to know even the most minutiae of details about each company. Buy-side equity analysts typically follow 40 to 70 companies. While they may not know as much detail as a sell-side analyst, if they make a sizable investment in a stock, they are expected to know just as much if not more detail than their sell-side counterpart.
While coverage for equity analysts is typically broken down into industry subsectors (for example, airlines would be a subsector of the transportation industry), fixed income analysts often cover the entire industry (which could equate to over 100 companies). So while there can be several equity analysts covering the transportation industry, there may only be one fixed income analyst. Debt markets are often less liquid than equity markets and do not trade on small pieces of information. Therefore, the fixed income analyst does not need to know as much detail about each particular company. However, should the buy-side fixed income analyst make a sizable investment in a company, it would not be surprising for him to know as much detail as an equity analyst.
3. Research Roles: Traditional vs. Alternative Asset Managers
While fundamental analysts generally perform the same function regardless of the type of firm, the role can be slightly different and is mainly driven by the investment time horizon.
Traditional asset managers often hire analysts and put them in charge of becoming “experts” in certain industries. Achieving this status takes years of diligent research and the traditional asset managers are often patient with their analysts as they build up industry knowledge. The research process for a particular company could take months before an investment is made. However, since both analysts and clients at traditional asset managers are typically long-term investors, they are very patient and will often wait years to capitalize on certain themes.
Alternative asset managers typically have a shorter time horizon as their clients depend on positive returns every year. They often do not have the luxury of waiting several years for investments to “pay off” as do traditional asset managers. Therefore, analysts at hedge funds often have to act quickly and decisively. They are not always categorized by industry but may cover several industries (and are then referred to as “generalists”). Oftentimes, a portfolio manager at a hedge fund may tell his analyst to research a particular industry in the morning and get back to him with the best investments by the afternoon. The day is often intense. One hedge fund analyst remarked, “I spent the early morning looking at airline stocks, the afternoon looking at retail stocks, and finished the day looking at credit card processors.”