Category Archives: Investment firms

dealing with hedge funds: …industry analysts

March 6, 2012 By in Industry Analysis, Investment firms Tags: , , , , , , , , 1 Comment

calling on customers

Two brokerage areas routinely call on corporations.  They are:

–investment bankers.  They’re somewhat like bank lending officers, in that they visits company to try to sell services.  In the investment banking case, that’s typically the possibility of stock or bond offerings, mergers and acquisitions advice or general consulting.

–securities analysts specializing in the company’s industry.  Analysts are members of the firm’s research department.  For smaller and privately held firms, the analyst will want to gather information that may be useful in his reports on publicly traded companies.  He’ll also want to set the stage for possible investment banking business with his firm as/when the company goes public.  For already publicly traded companies in the analyst’s coverage universe, the visit will be for updates–usually right before the analysts issues one of his periodic reports to clients.

Prior to 2000, securities analysts usually reported to the head of investment banking.  After the Internet Bubble-related scandals, where analysts were seen to have written inaccurate reports solely to stimulate demand for the stocks of companies their firms had brought public, that supervisory relationship has been broken.  I’m not sure there is a general rule about who supervises the research department today.

securities analysts

calling on clients

Securities analysts also spend a lot of time interacting with the firm’s brokerage clients, in the expectation that the client will trade with the firm–thus generating commission/spread profits–in return for the information provided.  This interaction may either be with the client’s own securities analysts, their buy-side counterparts, or with the client’s portfolio managers.  Communication may be by phone or e-mail or in person.

Like any other brokerage service, the appropriate institutional salesman will control/advise the analyst about the quality (phone or in person) and quantity of time he spends with a given client.  This will depend on the importance of the client to the firm, measured by the profitability of the relationship.

spreadsheets

Analysts or their assistants create spreadsheets to forecast company earnings.  They also write research reports that either analyze the company’s operations in detail, or highlight recent developments and their significance.  As well, they make buy, hold and sell recommendations for the company’s stock.

technical background?

In many cases, analysts will have worked in the industry they cover before moving to Wall Street.  They may also have relevant advanced technical degrees, such as in petroleum engineering for oil and gas analysts, or in electrical engineering for analysts covering technology hardware firms. (In my experience, such technical training can be a mild positive.  But it can also be a major hindrance, if the analyst mistakenly thinks this exempts him from having to do actual financial analysis of a company’s profit prospects.)

reliant on companies for information

No matter what their background, however, analysts remain very reliant on the companies they cover for industry and firm-specific information.  They’re also dependent on the continuing attractiveness of their industries to investors, whose commission business with the broker influences the analyst’s compensation.

In my experience, therefore, analysts tend to be a bit like home town sports announcers.  They’re highly reluctant to make negative assessments about their industries.  After all, that puts them out of work.  They also can be subject to considerable pressure from holders of large positions in a stock not to write anything negative about it.  Also, some companies may demand that analysts not only make positive statements but also adhere closely to company-issued earnings guidance.  Non-compliance can mean that the offending analyst is denied access to company management that’s routinely given to others.

Sounds crazy, doesn’t it?  But stuff like this happens.  The case of bank analyst Mike Mayo is perhaps the most famous recent case of this type.

A possible response to this pressure is for an analyst to give a “base case” in print, but to supplement this with a “whisper” number that’s noticeably different.  This will be disseminated to clients orally, with or without attribution to the analyst, but never put down on paper.

To be successful, analysts have to be good either at marketing themselves and their research to clients or at analyzing the companies they follow.  Of course, it would be better to excel at both, but in my experience that’s not necessary.  At one end of the spectrum there are (only a few) analysts who have completely pedestrian information, but are witty and know where a client likes to be taken to lunch.  For the majority who provide analytical insights, they come in several varieties:

–able to forecast earnings very accurately

–able to give a good qualitative appraisal of the industry and where all the companies stand within it

–able to say whether the stocks will go up or down.

These are all separate skills, and each worth paying for, I think.

 

 

dealing with hedge funds: institutional salespeople and industry analysts

March 5, 2012 By in hedge funds, Industry Analysis, institutional salesperson, Investment firms Tags: , , , , Leave a comment

a new SEC move

A little less than two weeks ago, the media heralded the opening of another in a long line of investigations by the SEC of insider trading involving hedge funds.  This time, those reportedly targeted include an institutional salesman from Goldman Sachs and the former head of GS’s research in Taiwan, as well as hedge funds who allegedly traded on inside information passed by the GS pair.

what do these people do for a living?

The press reports made me start to think that I should write on three associated topics:

–what does an institutional salesman do?

–what does a sell-side securities analyst do?

–why the focus on hedge funds?

three posts, starting today

I’ll answer these questions–from my perspective as a former client, never myself having been a hedge fund principal, an institutional salesperson or a sell-side analyst–over the next three days.

Before I start, though, I should say that the brokerage landscape has been changing, with increasing speed, over the past decade, and to the detriment of many institutional salesmen and industry analysts.

Two reasons:

–pension fund clients and mutual fund boards of directors are paying increasing attention to the amounts paid by traditional long-only investment managers to brokers.  This is only natural, since this money comes out of the pockets of the clients, not the managers (more about research commissions in Wednesday’s post), and

–increasingly, successful traders (think: Jon Corzine) have become the heads of major brokerage firms.  They’ve been reshaping the firms in their own image, and shifting emphasis away from areas like research and institutional sales.

what does an institutional salesperson do?

An institutional salesperson is a marketer.   He’s is in charge of the overall relationship between the broker and a specific set of money manager clients.  The job is to ensure that the broker makes a profit on each client relationship.

The institutional salesperson is a gatekeeper, in two senses:

–he regulates access to brokerage services, depending on the level of client payments.  “Access” includes things like: phone calls or private visits from industry analysts; private meetings with companies on road shows hosted by the broker; one-on-one company meetings at broker-hosted industry conferences; favorable allocations of initial public offerings (the salesman is only one of several parties in this discussion, though).

–he also regulates the timing of access.  Does a requested analyst drop everything he’s doing and rush to the client’s offices?  …or does he make a phone call the following day?  Is a company meeting for an hour at 10:00am?  …or twenty minutes at 5:30pm?  …or a conference call, instead of face to face?  …or a canned presentation at a group lunch?  If the salesman makes personal calls to relay information from the broker’s morning meeting (in addition to internet dissemination) about companies he knows the client is interested in, who is the first call and who is the tenth?

relationship:  commercial to emotional…

As is the case with any effort to sell recurring services, part of the job is to try to turn a commercial relationship with the client into a personal one.  To that end, institutional salespeople study and cultivate their clients very carefully.

In my experience, salespeople know much more about the client and what makes him tick than he would ever dream.  If the client likes to be taken to lunch or to sporting events, fine.  If the client likes to gossip about rivals, okay.  If he likes flattery, so be it.  If the client responds better to salespeople who are tall/short, young/old, male/female, slim/portly, sports nut/nerd–even if the client is unaware he does so–assignments will be altered to suit. (I’ve even seen one brokerage house–long since merged away–that wanted to establish a certain image.  It had only salespeople who were young, slim, good-looking and very tall.)

…or maybe not

An intelligent salesperson (and that’s just about every one I’ve come into contact with) also makes judgments about the client’s overall business.  Is it on the rise, or has a former hot hand turned permanently cold?  Adjustments are made, accordingly.  One of my friends used to classify clients explicitly in terms of the BCS matrix.  I never asked where I stood.

information collection

The salesperson also has an information gathering function.  Particularly in the US, money managers take pains to separate research decisions made by portfolio managers and their implementation through the trading desk.  One reason is to disguise their investment strategy from their trading partners (another is to guard against bribery).  However, experienced institutional salespeople can often ferret out information by reading between the lines in their conversations with clients–data which is immediately relayed to the broker’s trading desk.  Salespeople also usually know their clients’ analytic strengths and weaknesses very well.  If they believe a key client is buying a stock in an area where he’s an expert, the salesperson may give other clients an extra nudge–after alerting the trading desk, of course.

In a good year, an experienced institutional salesperson in the US can make millions of dollars.  And a strong working relationship with a client who becomes a super-star manager can make an institutional salesperson’s career.  On the other hand, high compensation also makes someone like this an obvious target for downsizing during a period of brokerage retrenchment like the one we’ve been going through over the past few years.

Back to the media reports on the SEC investigation:  can an institutional salesperson develop inside information on his own?  Maybe, but that would be very unusual, in my view.  I think a more likely accusation would be that a salesman either traded on inside information himself or passed it on to a client who did.

Tomorrow:  the sell-side securities analyst.

 

 

another sign of a toppy bond market in the US

February 28, 2012 By in Constructing a Portfolio, Current Market Thoughts, ETFs Vs. Mutual Funds, Industry Analysis, Investment firms, Recent Market Action, Strategy Tags: , , , , , Leave a comment

running an ice cream stand

One of the most useful tips on company analysis I’ve ever gotten came from a former P&G marketing executive who was working for a hotel company when I heard him speak.

He said that if you run an ice cream stand that sells vanilla ice cream, you don’t start to sell strawberry (my favorite, by the way) until the market for vanilla stops growing.  In other words, once you see a company begin to segment the market for a product (by offering several varieties), you know that sales of the “plain vanilla” version are tapping out.

the new Pimco Total Return ETF

That’s my take on the Pimco announcement that it’s launching an ETF version of its total Return bond fund, the largest actively managed bond mutual fund on the planet, two days from now.  It means investors have stopped buying bond mutual funds from Pimco.  Since Pimco is the biggest bond manager and has the best long-term record, I think this also means investors have stopped buying bond mutual funds, period.

Remember, too, that Pimco–a unit of Deutsche Bank–is a marketing monster.  It’s executives are constantly pounding home their message, often packaged as “economic” commentary, that now is the best time to buy more bonds.  During the two decade+ period of secular long-term interest rate decline that ran from the early 1980s until recently, that stance was 100% correct.  Not anymore, though.

True, Pimco had a year to forget vs. peers in 2011.  But I don’t think that’s the issue.  Pimco’s long-term record is strong.  And the company had begun laying the groundwork for the new ETF before its performance weakness unfolded.  Despite Pimco’s relentless sales efforts, I think investors are finally catching on that bonds may not be the one-way street that they’ve come to expect.  Even if the light bulb hasn’t gone on, investors are at least signalling that they don’t think they need any more bonds.

ETFs aren’t a walk in the park

performance differences

Many bonds are surprisingly illiquid.  Pimco won’t be able to use the much more easy-to-trade derivatives market to change the shape of its ETF holdings in the way it does in its mutual fund portfolio, however.  So it’s possible that the ETF won’t track the mutual fund very closely.

That’s potentially a big concern.  Holders of the vehicle that’s doing less well will always be unhappy.

filling a need nobody has

So far, actively managed ETFs haven’t been very popular with investors, who have preferred low-cost passive products.

cannibalization

Cannibalization of the Total Return mutual fund by the lower-cost ETF might seem to be an issue, but I don’t think it is.  Two reasons:

–taxable investors with unrealized gains on their mutual fund holdings won’t switch to the ETF because they’d trigger capital gains tax

–it’s always better to cannibalize an existing product with a new one of your own rather than have a rival do it to you with one of his.

conclusion

The new ETF will be interesting to watch, if nothing else to see how successful it is in gathering assets.   Still, I think it’s probably as close as we’ll get to a bell ringing to signal the top of the market.

layoffs on Wall Street: where do people go?

February 20, 2012 By in economics, employment, hedge funds, Industry Analysis, Investment firms Tags: , , , , , 1 Comment

The weekend Financial Times has an interesting article about the decline in financial markets employment during the Great Recession.  It says that the industry lost over 200,000 workers, of whom more than 40,000 were relatively highly paid professionals.  The article relates a number of stories of transition to other kinds of work.

That’s basically what happens in investment-related businesses during downturns–people find other, unrelated industries to work in.

Looking at the situation a little more systematically,

finance has two main branches–three if you count the often bizarre area of financial “theory” that prospective finance teachers must master.

–commercial finance, commercial banking and corporate finance.  It deals with areas like lending, capital structure, budgeting, financial management controls, investing/raising cash for corporations, communicating with investors and regulators.  It’s generally insulated from the violent ups and downs of securities markets.

–investments, which deals with the structure and practices of securities markets.  People who focus on this branch of finance are generally much higher paid and much more highly specialized.

While it’s common for a commercial finance professional to move among different areas during a career, however, there’s virtually no carryover in skills, other than at the most basic level, from the investment specialty to the broader world of commercial finance.  In fact, other than early in one’s career, there’s very little movement possible among various areas–like stocks, bonds, trading, investment banking–within investments.  Career paths are that highly specialized.

This is a recipe for big career trouble for investment people if your sub-specialty suddenly has too many workers.

buy side vs sell side; professional investors vs. investment professionals

The industry commonly splits jobs into buy-side (investment management) and sell side (investment banking and brokerage).  There’s also typically very little movement between these two.  You can also distinguish between professional investors (the people who actually make investment decisions) and investment professionals (trading, sales/marketing and recordkeeping functions that provide services to portfolio managers).

professional investor issues.  The main industry problem over the past several years has been the decline in the value of assets under management.  This is the key problem for profits, since professional investors typically charge a percentage of assets under management as a fee.  Investment firms are also highly operationally leveraged–meaning they have roughly the same costs, no matter what the level of assets is–so the loss of assets under management results in a disproportionately large fall in operating income before compensation of portfolio managers.

The moves to index products and from equity to fixed income, both of which generate lower fees, haven’t helped, either.

What do investment management firms do?  They prune the least profitable products, eliminate staff and lower the level of compensation for almost everyone who survives.  There isn’t much else they can do.  Laid-off money managers either go into business for themselves (massive layoffs of value-oriented PMs in the late 1990s formed the basis for much of today’s hedge fund industry) or find smaller, often regional or local, firms to work at.

investment professional issues.  On the buy side, firms trim their trading and marketing staffs and lower compensation for those who remain.  The investment industry is mature, however, meaning there are few new customers.  So firms gain business mostly by taking it away from other firms.  So marketing is a vital function–more important than the investment management itself.

On the sell side, it’s important to distinguish between high-value employees, who are masters of their trading or investment banking trades, and low-value workers, whose main function is to act in a sense as “overflow” capacity.  That is, they answer the phone and process orders, or visit clients and make presentations, during cyclical peaks in business.  They may not add much value, but the firm avoids losing potential profits by being unable to respond, even badly, customers’ requests.

Such second-tier workers are paid a lot, both in absolute terms and relative to the value they add.  But when business slows down, they’re the first to be laid off.

First-tier investment professionals typically earn (much) less in lean times.  They also risk being laid off, as well.  Like their portfolio manager counterparts, they may end up at regional or local firms.  Boom times give second-tier workers an inflated sense of their own abilities.  Typically, though, they’re unable to remain employed in the investment industry during downturns and eventually end up working in other professions.

where are we now?

My sense is that the investment industry is at a cyclical bottom for employment.  But the industry still has enormous idle capacity available with the staff it now has.  We won’t see the boom times of 2004-2007 again soon.

higher taxes on dividends? –implications for stock markets

February 17, 2012 By in cash flow/share vs. earnings/share, Constructing a Portfolio, currency effects, Current Market Thoughts, Dividends, Industry Analysis, Investment firms, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , Leave a comment

the Obama proposal

President Obama has recently proposed that the current tax preference for corporate dividends paid to individuals be eliminated.  Instead of being taxed at most 15% of the amount received, dividends would be considered ordinary income and taxed by Washington at as high a rate as around 40%.

Personally, I’d prefer an overhaul–and simplification–of the current tax code instead of tweaks around the edges.  Rather than putting a foot into the  the quagmire of possible political motivations, however, let’s just take a look at what I think are likely results for US capital markets if it’s implemented.

what doesn’t change

1.  Tax-exempt and tax-deferred accounts would be unaffected.  For pension plans, 401ks and IRAs, and for non-profits, it will continue to make no difference whether they make money in the form of interest or dividend income, or of short-term or long-term capital gains.

2.  Aging Baby Boomers are developing an increasing preference for steady income over capital gains, which are sometimes there, sometimes not.  That won’t change either.

what does

3.  I think the biggest effect will be on company decisions to start making dividend payments or to increase a payout they already have.

It seems to me that most publicly traded corporations recognize the Baby Boom-induced change in investor preferences now happening in the US.  Understanding that a substantial, and rising, dividend is a positive for their stock, companies have been happy to return profits to shareholders this way.  They do this despite realizing that if you combine federal and state/local income levies, up to 25% of the payout will go to the taxman.

If dividends lose their tax preference, the percentage taken by the taxes will approach 50%.  That means a big drop in what the shareholder will retain, both numerically (a third) and psychologically.  For most companies, I suspect, it will tip the balance in favor of devoting free cash flow to share buybacks rather than dividend increases.

For my money, that takes a lot of the shine away from what I consider to be the most attractive part of the dividend-stock universe–companies with above-average dividends today and for which you can reasonably project a quickly rising free cash flow over the next few years.

4.  If the government continues to  keep interest rates at emergency lows and, by accident or design, it also removes much of the incentive for individuals to buy dividend-paying stocks, how do investors adjust?  Maybe there’s a boost in demand for junk bonds, although income-oriented investors have been buying riskier forms of fixed income for a long time.

I think biggest effect would be for investors to broaden their horizons further.  The 7%-8% yields on EU telecom stocks will suddenly look more attractive, despite currency risks.  So, too, emerging market securities, both bonds and dividend-paying stocks.

5.  Looking at #3 another way,  provided they’re large enough to lower the share count, stock buybacks raise earnings per share.  All other things being equal, that should mean a higher per share stock price.  If so, the higher share price would likely offset some or all of the negative effect of dividends increasing at a slower rate.  In other words, the mix of returns (price appreciation + dividend income) changes, and in a way that increases risk.  But the crucial investment question is whether the total return from both sources will be higher or lower than before.

No one knows the answer.  But if the total return is lower–that is, if the effect of higher taxes on dividends is to decrease the long-term value of US equities–then one would expect US investors of all stripes to look increasingly to stock markets outside the US.  In addition, on the margin, US companies might also begin to look to foreign venues to raise new capital, if they could achieve higher prices for their stock by doing so.

My bottom line:  this proposal is one to watch closely.  Like a snowball that starts rolling down a hill, its consequences could be far greater than just to raise taxes on older, upper middle class city dwellers.

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