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December 8, 2011
By Steven Greer, MD (former financial analyst on the sell side and buy side, and portfolio manager within a $10 Billion fund)
The bad economy and large volatility in the markets has made for yet another challenging year. It is easy to point fingers of blame for struggling portfolios. However, there have been plenty of stocks in healthcare that made large gains, and plenty of stocks that have imploded and were good shorts.
Statistically speaking, there is a good chance that your analyst was not picking these few alpha winners. Why did they miss these contrarian stock picks?
There are some common pitfalls that financial analysts fall into. As a PM managing the analysts, you know of these hazards well, but you might find it interesting to read our list anyway.
- Does your analyst lack the courage to think independently? Does your analyst require the validation of the sell side shop notes before they will jump on the bandwagon of a stock thesis? One of the big mysteries in investing is how sell side research still has the relevance that it has. The most junior of analysts all know that the stock ratings are a joke, that sell side analysts are bad stock pickers bogged down with conflicts of interests, and so on (there are some exceptions). Yet the vast majority of buy side analysts still get herded around like sheep by the leading sell side analysts. They end up buying too late or, more commonly, holding stocks despite obvious risks that have been downplayed by cheerleading sell side research.
- Does your analyst rely more on networking and talking to other analysts than on creating original work? The biotech sector analysts are the worst at this, and it is the reason many PMs were led over cliffs in DNDN, etc. If your analyst spends more time on the phone than on building models or doing field checks, etc, then there is a significant risk that you, as the PM, are being fed the same ideas circulated throughout the Street. This is another manifestation of herd mentality.
- Does your analyst think that the investing process is a big game meant to be rigged. Do they think that their cartel of friends can change reality? Scores of examples of biotech stocks imploding 70% after reality won the day can be recalled by any PM. In many cases, the analysts knew of the particular risk causing the implosion and thought that they could scam the system and change reality. For example, a concerted cartel of oncologists, investors, and small blogging journalists helped to get the controversial Dendreon therapy approved despite weak clinical data. They succeeded in delaying reality for a while. However, once Provenge was approved, the real world oncologist wanted nothing to do with it. Dendreon is a now a distressed company.
- Have your analysts become entitled due to the pandering sales reps? Mutual fund analysts are very susceptible to this. Analysts at large hedge funds that pay sizable trading commission are also vulnerable. The hubris that ensues after sales reps cater to your analysts is the downfall of a stock picker. Behind every large stock implosion that cost some large fund hundreds of millions of dollars was an entitled analyst that got lazy and arrogant.
- Is your analyst simply lazy? Not all sell side research is crap, and any sell side analyst will tell you that most of their good notes go unread. Does your analyst even read the research that you, as a PM, pay good money to receive?
- Does your analyst have the insight and training required? Many analysts do not have the medical and sell side training to allow them to distinguish important research ideas from bad ones, or to see through company spin. Over the last decade, when the number of hedge funds exploded, far too many entitled “Harvard MBA” types went straight from B-school to stock picking, without any training other than a useless degree. Investment banking, sell side research, and industry business development best prepare an analysts to fight on the front lines and pick stocks for a living.