Modelling analyst behaviour
In this post, I will try to find patterns in the behaviour of sell-side analysts. How do analysts typically behave, and how can we use that knowledge to make informed buying/selling decisions?
First, a few observations about how sell-side analysts typically behave:
Early in the career of a sell-side analyst, they typically start out with deep investigate research. Since no clients clamour for their attention, they are able to learn everything there is to know about a particular company or industry. Many analysts start out with a belief that research should be objective and help clients make rational decisions. But over time, they increasingly feel the pressure from banking colleagues and companies under coverage to embellish the truth. They learn to push the company’s narrative rather than to form their own independent views.
As long as the analyst has a positive view on the prospects for growth and profitability – no problem. Once he starts sending out reports that question management integrity or question the viability of their business, he might find themselves cut off from information flows. The company under coverage may ban the analyst from visiting them, ban him from talking to its executives or ban him from attending investor calls. Companies can also decide not to visit investor conference organised by the bank that the analyst is working for. There is a lot at stake for management teams: a high share price is in their interests as it enables them to
- Avoid being acquired by other companies and thereby displaced by another management team
- Boost the value of their own stock options
- Create a valuable acquisition currency that enables them to pursue “empire building”
Management teams in established bureaucracies tend to like analysts who are calm, steady and respectful while management teams in start-ups run tend to like analysts who aggressively push their stocks.
Companies undertaking mergers & acquisitions or capital raises tend to choose investment banks that have highly ranked analysts. Just as fund managers never get fired for buying IBM, business development executives don’t get fired from choosing a banker with a highly rated analyst. During these transactions, company executives will have additional leverage over the analyst to make sure that he is positive on their stock before. Sometimes, analysts may even have employment contracts that let them have a cut of any banking business. Given that analysts often come along their investment banking colleagues on roadshows, the banking clients will have a direct way to size him up. Before an IPO, a CFO will typically sit down with all underwriters and co-managers to make sure valuation assumptions are “correct” (i.e. bullish). Due to ever-stricter enforcement of figurative Chinese Walls, banker colleagues cannot tell analysts directly what to write, but they can indicate their displeasure indirectly or require them to send over reports for “proof-reading” as a way to give them psychological pressure. On the other hand, if the bank is not doing any deals at the moment, bankers are unlikely to go out of their way to influence analyst opinions. The best fee machines for Wall Street are the companies who constantly raise money by selling bonds and shares.
The bank’s internal sales force and retail investors love stocks that have some kind of romance, or the possibility of a hot stock. They want a simple story: a simply buy/sell recommendation and a simple justification. No ifs, buts or caveats. So analysts are forced to dumb down their picks. The way to make a splash is to sensationalise and to use simple arguments. Salespeople love tidbits of news they can pass on to their favoured buy-side clients.
Analysts are typically judged on the basis of rankings published by Institutional Investor, Euromoney, Nikkei, etc. As large-AUM clients often have a bigger weight in the votes, analysts tend to favour large institutional clients via preferential access to news, company managements, and their own time and attention. After writing a report, the analyst will call his favourite institutional clients to flag the news before it has become obvious to the broader investor community. To serve them well, the analyst therefore has to have cordial relationships with company managements, and essentially trade bullish opinion for company access. How accurate the stock picks are does not matter very much – the job is more about doling out attention and make clients like the reports. Having a strong difference of opinion with a major investor client is not a winning strategy, so the analyst is incentivised to reinforce the existing beliefs of investors. Deep analysis may be rewarded in rankings, but in the every-day routine, analysts are more concerned about keeping up with the short-term demands of the business: instant responses to clients rather than deep, investigative analysis.
Analysts do love to find new undervalued stocks, publish reports before other analysts do, help their clients make money and support investment banking colleagues winning M&A and capital market deals from the company. But at the same time, if an analyst is wrong about a particular forecast, he will look like a complete idiot. So there is an incentive to keep to verifiable facts and avoid taking positions that are too controversial. If management provides analysts with non-GAAP numbers, analysts are unlikely to go out on a limb to question them. If they are proven wrong, they can always blame management for their error. Investors also like it when an analyst has a clear and consistent position and does not change his mind too often. It raises the question of whether the analyst was incorrect in his previous recommendation. Stock recommendations are a relative game: analysts want to cover a new company first and have better recommendations than others. If every analyst on the street is proven wrong in his forecast, at least they are all in it together.
In a worst-case scenario – if something goes wrong with a stock – the analyst will have to change his recommendation quickly. He will typically start out by seeking the opinions people he respects. If the analyst is close to the management team, he will initially seek their reassurance and perhaps even organise a call to refute the allegations of slower growth/fraud/etc. If investors and the press turn into attack dogs, analyst will have to become defensive and more conservative in his forecasts – generally just trying to avoid making any mistake. But if it is clear that a fraud has been uncovered, the analyst will have to downgrade the stock. Class-action lawsuits may be directed at the investment bank for recommending retail investors to buy it, at least in the United States. Furthermore, being bearish in a bull market or bullish in a bear market can destroy a career, so analysts are more or less forced to become trend followers.
Different clients obviously want different things from the analyst: 1) hedge funds often want stocks to go down 2) bankers and long-only funds want stocks to go up 3) in-house traders and retail brokers want coverage of volatile small stocks that can generate commissions. So different analysts may focus on different parts of the investor client population. In order to gain the most number of votes, however, tending to the needs of large-AUM clients should be a winning strategy.
We can now make the following generalisations:
- Analysts tend to have a bullish bias at all times
- Analysts love finding new ideas. If a broken IPO stocks for example is taken up coverage at a major bank, then other analysts will soon follow with their own recommendations
- Since sell-side equity research is a relative game, if consensus is moving in a certain direction every dissenting analyst will be tempted to change his mind
- Since analysts tend to stick to verifiable facts and don’t like going out on a limb, major events 6+ months into the future may not be priced in
- As analysts’ main goal is to keep large-AUM clients happy, their research will typically reinforce consensus views on a stock
- When a major negative event happens (fraud, disappointing top-line growth, etc.) and it reaches a critical mass, a wave of downgrades of cessation of coverage will follow
The above factors contribute to stock prices exhibiting a boom-bust pattern that start with an exciting idea + an accelerating growth rate, and end with a disappointment.
Which stocks are most likely to exhibit boom-bust patterns for reasons that have to do with analyst coverage? The above observations lead us to conclude that stocks most likely to have violent swings around “intrinsic value” are the ones where:
- The story is exciting: a growth company in a new industry
- The company is a start-up rather than an established bureaucracy
- It is difficult to value the company in exact terms
- The people in the management team are “hired guns” rather than major shareholders
- The management team has significant amounts of out-of-the-money stock options
- There is ongoing M&A
- The company is in dire need of capital
- A major shareholder (such as a private equity fund) is looking to sell down its stake
Out-of-sample test: Fairmount Santrol (FMSA.US)
Fairmount Santrol produces sand solutions used in hydraulic fracturing of oil & gas wells. The company went public in June 2014 in transaction handled by Morgan Stanley, Wells Fargo, Goldman Sachs, KeyBanc, RBC, JP Morgan, Jefferies and a number of co-managers. The company did not realise any proceeds from the IPO, but management sold down part of their shares – as did the major shareholder American Securities LLC, a private equity fund. The PE fund acquired its shares in 2010 and levered up the company as part of an LBO.
The story was exciting. Sand proppant use was growing exponentially due to the higher amount of sand needed for hydraulic fracturing vs conventional drilling. Shale oil & gas was and may still be an exciting growth industry for the United States – energy independence for the United States was the mantra of the day. While Fairmount Santrol was hardly an exciting tech start-up – they produce sand after all – the company had grown its top-line 20-30% per year in the years prior to 2014. The CEO owned 4.3 million shares after the IPO, worth $70m at the IPO price. The company was difficult to value: partly due to its significant debt load and partly due to the uncertain prospects for supply & demand in the sand proppant industry.
When oil prices started coming down at the end of 2014, it brought the share price with it from $16 to $1.5 in early 2016.
The company’s CFO quit in September 2015. A new CFO was then appointed on 10 march 2016. On 20 July 2016, FMSA issued 25m shares at $5.95 to shore up its balance sheet and enable American Securities to sell down its stake. The transaction was handled by Morgan Stanley, Wells Fargo and Barclays. On 20 October 2016, FMSA priced another secondary offering of 30.25m shares at $9.45 with Morgan Stanley as the sole underwriter. On 2 December 2016, yet another secondary offering of 20m shares was priced at $8.75, again with Morgan Stanley as the sole underwriter.
Now, let’s observe analyst behaviour around these events (counting every Outperform / Overweight / Buy recommendation as a “Buy” and every Underperform / Underweight / Sell recommendation as a “Sell”). At the time of the IPO, 6 analysts had an Outperform recommendation and 4 analysts had a Hold recommendation. Out of the bookrunners, KeyBanc initiated at Buy, Goldman Sachs at Hold, Morgan Stanley at Buy, RBC at Buy, Jefferies at Buy and Wells Fargo at Hold – so 4 buys and 2 holds. After the first drawdown, RBC and Jefferies downgraded to Hold. At close to the trough in the share price chart, Cowen, KeyBanc and Simmons all downgraded to Hold, Hold and Sell, respectively. But just after the new CFO was appointed in March 2014, the rig count started to rise and the oil price stabilised at around $30-40/barrel, the upgrades started coming. GMP Securities and Simmons upgraded the stock in May. Around the time of the first capital raise in July, Citi wrote an initiation report and analysts at Wells Fargo, Jefferies, Cowen, Piper Jaffray upgraded the stock. Barclays restarted coverage and Credit Suisse initiated just before the company’s second capital raise. Note that Morgan Stanley kept its overweight recommendation throughout the dip and the rebound.
Since the IPO, Fairmount Santrol has participated in 5 conferences: Barclays’, Scotia Howard Weil’s, Goldman Sachs’, Cowen and Jefferies. These banks all covered the stock, but not all of them had a Buy recommendation at the time of the conference.
Key things to note:
- The stock qualified as one where analysts were more likely to be bullish: a need for capital to shore up the balance sheet, a selling shareholder in American Securities, and significant incentives for management to push the stock price higher
- Downgrades and upgrades happened in clusters. Once fundamentals turned terrible – the stock was down 90% in early 2016 – several downgrades came at the same time. As the rig count number reversed its downtrend, oil prices stabilised, and the company started raising capital, most of the analysts upgraded at almost exactly the same time. It is unclear how to differentiate between cause and effect: Did a higher share price cause the company to issue more shares? Or did the prospects of a capital raise lead analysts to upgrade stock, leading to a higher share price?
- Morgan Stanley had the privilege of being the sole underwriter at two secondary offerings, perhaps due to its continuously bullish stance
Out-of-sample test: Avago/Broadcom (AVGO.US)
Avago (now renamed to Broadcom) is a roll-up in the semiconductor industry run by Singaporean Hock E. Tan. It has been on a buying spree since 2013, buying up CyOptics and Javelin Semiconductor in April 2016, LSI Corp in December 2013, PLX Technology in June 2014, Maxim Integrated Products and Xilinx as well as a merger with Broadcom in May 2015, Marvell Technology in March 2016 and Brocade in November 2016. The strategy is simple: buy a company, cut fat and leverage up to buy additional companies. US private equity firm Silver Lake took a position in Avago in early 2014. Throughout this process, the stock price has done extremely well, rising from $30 in 2013 to $179 today. A surge in the sales of smartphones and other electronic devices may have helped as well.
Let’s dial back to 2013 when Hock E. Tan had just started on his acquisition spree. At that time, only a few sell-side firms such as Jefferies covered Avago. Shortly after the CyOptics and Xilinx acquisitions, however, a number of sell-side firms took up coverage: Craig-Hallum, Morgan Stanley, JMP Securities, MKM Partners and Oppenheimer. After the LSI deal, Goldman Sachs upgraded the stock, as did UBS and Nomura. From 2014 until today, the number of analysts covering stock has gone from 15 to 33, with practically all analysts putting either an Outperform or a Buy on the stock. Only one out of 34 analysts has a Hold rating. The investment banks were rewarded with M&A deals: long-time allies Deutsche Bank, Citi and Barclays won most of the advisory roles. Analysts are forecasting EPS many multiples higher in 2017 than the levels in 2015 – expectations are very high.
The story is exciting: a relentless cost-cutter improving operations on an ever-greater scale, creating revenue growth of 60-70% per year in the process. The CEO is charismatic and has a god-like status among investors. Given the growth rate, it is difficult pinpoint what the intrinsic value might be – especially since investors seem to think acquisition-led growth adds as much value as organic growth. Hock E. Tan’s bonus is determined on the basis of top-line and operating profit growth. In 2013 and 2014 he also received options exercisable into more than 1 million shares. Lastly, Silver Lake may be looking to exit its 2.7% stake at some point.
Key things to note:
- The stock is in the sweet spot of stocks that are likely to get positive analyst coverage: recurring M&A transactions, a hot story, a start-up mentality in the management team, a private equity investor looking to exit at some point, difficult-to-value assets and a CEO that is incentivised to push up revenue growth and boost the share price
- Analyst coverage really took off after the first acquisition in 2013. Since then the number of analysts covering the stock has almost doubled. To some extent, a higher market capitalisation after the merger with Broadcom may justify the broader coverage.
- The banks that won investment banking deals all covered Avago before the company became a roll-up
- Almost much none of the analysts use GAAP EPS to use as a base for extrapolation into the future. They all assume that amortisation expenses don’t reflect real economic costs for the business – as if patents and accumulated R&D can be acquired without any payment. I take issue with this of course. But as long as Avago doesn’t disappoint with their non-GAAP earnings, the stock may continue to hover at the current EV/Sales ratio of 7x or higher.
A number of strategies that can be used to benefit from patterns in sell-side analyst behaviour:
- If you own an exciting stock that does not yet have any analyst coverage, send an e-mail to analysts that cover similar stocks to inspire them to initiate
- Look for stocks that analysts have just started to write initiation reports on – chances are that more and more analysts will jump on the train
- Visualise events in the future that you think analysts will have to react to
- As long as the story is intact and some of the analysts are still sceptical, stay long
- If a portfolio holding is suddenly unable to meet bullish analyst expectations, sell as soon as you can to avoid an avalanche of further downgrades
- Buy early-stage roll-ups
- Don’t short stocks that have funding needs or is involved in a series of M&A transactions in the near future, at least not until the story has broken. Also avoid shorting hot and exciting story stocks where management is highly incentivised to prop up the share price