Almost everyone I meet on the buy side has a story about a sell-side analyst they hired who didn’t work out. Most are able to extrapolate from just one or two isolated incidents like this into some complicated theory of how evil incarnate emanates from the sell side, but most of the available research, as well as my own experience, refutes these theories categorically. Boris Groysberg, et al March 20071, found that buy-side forecasts were just plain inaccurate, and that buy-side analyst’s recommendations consistently under-performed sell-side recommendations, despite all the well-documented conflicts of interest in sell-side research. But forget about that. Groysberg found a couple of other things that were even more disturbing:
1. Buy-side firms who rely solely on sell-side research out-perform those that hire their own internal analysts.
2. Buy-side firms who hire from the sell-side do not hire poorly, but the performance of sell-side analysts deteriorates substantially after joining the buy-side.
huh?
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My experience as head coach for a team of 15 analysts was significantly different from what appears to be the norm, and I have some thoughts about this that I’d like to share. In our case, even long after joining our firm, the analysts with primarily sell-side experience vastly outscored their colleagues with primarily buy-side experience in every category that we kept data on, except the very subjective category of teamwork, where they scored dead even.
Groysberg hypothesized that the sell side’s stronger performance is a result of much more competitive environment. Our environment was highly competitive and extremely hard on the ego. Everyone’s recommendations were available to everyone else – there was no privacy. The performance of every recommendation was tabulated relative to each analyst’s benchmark and everyone’s track record was public. In addition, the implementation team, consisting of a PM, Chief Trader, a trade-desk analyst, and myself were all constantly in touch with key sell-side analysts, and sell-side ideas were as likely to get into the portfolio as internal ideas, possibly more so. At the same time, we were totally intolerant of any behavior that might stifle an idea or hurt someone’s feelings. Constructive debate was always encouraged, but no one was ever allowed to make personal or degrading comments. Analysts and fund managers alike were expected to make mistakes on a regular basis. If they didn’t make enough mistakes, I knew they weren’t really trying hard enough. About the only thing you could get scolded for was being rude to a broker.
Groysberg also hypothesized that the sell side benefited from significantly higher frequency of meetings with management. In our case, we snuffed this disadvantage out completely. Our analysts made as many as 5 management contacts per day and were encouraged to never have lunch or dinner alone. Often the contact was no more than a phone call, but for the average analyst, this meant more than 1,000 meetings or phone calls per year.
Another advantage of the sell side is that they spend about 30% to 50% of their time marketing, and through these inter-actions with institutional investors, they subject their ideas to very broad scrutiny. Most buy side analysts get none of this and are pretty happy about it. One of my most important and most difficult roles was to read and provide feedback to every written report that went into our research data base. It would have been a lot easier, but remember, I wasn’t allowed to say anything that would hurt anyone’s feelings. Analysts were also required to submit to a weekly grilling by the implementation team. None of the analysts enjoyed this, and we ran up against a great deal of resistance when this system was first instituted, but I could see very clearly that analysts were preparing their arguments much more effectively once they knew that there would be scrutiny beyond the mere thumbs up or down by the PM.
There was one thing that Groysberg didn’t think of though, and that was probably because it would go against everything his finance professors ever taught him, and, yet it is probably the most over-bearing and pointless burdens that any asset management company ever straps on its analysts. Sell side analysts are free to find whatever works for them and their sector. They are usually free to find whatever fans they can from a multitude of massively divergent clients. And because each industry and each analyst is different, what works for one is unlikely to work for another. Rivalry within the brokerage community helps to ensure that a larger percentage of analysts are likely to be on the cutting edge of whatever is working at any given era.
But once a great analyst enters the Dark Side of buy side investment policies, there will usually be a single methodology that is approved to the exclusion of most others. This is so widespread that most firms just assume it is the common sense thing to do, and it is, provided your objective is to destroy creativity, motivation, and performance all in one go.
We never screened our recruits for investment style. If someone has figured out a way to beat the market consistently, we didn’t really care how they did it. In fact, if they weren’t doing things a whole lot differently than we were, it didn’t make much sense to hire them. My job was to figure out what their edge was and try to prevent our corporate culture from sabotaging it. Allegorically, I was offering them my umbrella, to shield them from the constant rain of irrelevant bullshit and idiotic policies that prevade almost any well meaning establishment.
A good analyst is knowledgeable, creative, courageous, and hungry. In my view, a buy-side operation is a costly and ineffective environment for teaching any of these skills. Let the sell side do this, and learn how to manage the wealth of resources that spring up from this inexhaustible well.
Groysberg, Boris, Healy, Paul M., Chapman, Craig J., Shanthikumar, Devin M. and Gui, Yang, Do Buy-Side Analysts Out-Perform the Sell-Side? (March 2007). Available at SSR
Buy side portfolio managers and analysts are often encouraged to use “the street” for background but not as the basis of BUY/SELL judgements on the premise that whatever “the street” says is already in the market. This may or many not be true. The most fun thing is to find out through independent analysis when a well-followed sell-side analyst’s call is erroneous due to faulty information or understanding and to take the opposite side. It is true, though, that if he has enough credibility and enough people do what he says without checking his assumptions for themselves, it may take a while for the correct call to bear fruit…..