insider trading, hedge funds, expert networks and skilled securities analysis (ll)

In yesterday’s post, I wrote about what insider trading and expert networks are.

Why have expert networks flowered over the past decade and been especially favored by hedge funds?

hedge funds

When I started working in the stock market in 1978, it was common for both brokerage houses and large institutional investors in the US to have extensive staffs of analysts.

As the sell side continued to rebuild itself and improve its analytic capabilities after the 1973-74 recession, buy side firms worked out that they could save money by shrinking their own staffs and rely on brokerage house research instead.  Better still, from their point of view, they could pay for access to the brokers’ analysts through commission dollars (“soft dollars”), a tab picked up by money management clients, rather than paying analysts’ salaries out of the management fees clients paid them.

Control of brokerage firms gradually passed into the hands of traders, who regard research as a cost center that produces no profits.  They did what seemed the obvious thing to do and began to lay off analysts.  During the Great Recession of 2008-2009 the steady trickle of layoffs became a torrent–and gutted the major brokers’ analysis capabilities, particularly in equities.

The professional disease of analysts is that they analyze everything, including their own jobs.  Senior people have long known that they’re vulnerable in a downturn, especially since they all are compelled to have assistants who earn a small fraction of what they do–and who can sub for them in a pinch.  Their response?  –in many cases, the senior people hire assistants who look good in business attire and can present well to clients, but who have limited analytic abilities.  As far as I can see, this defense mechanism protected no one during the fierce downturn recently ended.  It may be harsh to say, but “place holder” assistants may be all that’s left in some research departments.

If the cupboard is pretty bare in brokerage house research departments, do hedge funds build their own?

Some have.  But–and this could be nothing by my own bias–a lot of hedge funds are run by former brokerage house bond traders.   Traders and analysts are like the athletes and the nerds in high school.  Very different mindsets.  So hedge funds that are run by traders, and that have a trading orientation, don’t have the temperament or the skills, in my opinion, to build research functions of their own.  They also want information that’s focused strongly on the very short term.  (Is it a coincidence that the subjects of the recent FBi raids are all run by former bond traders?)

They can’t get it from brokers.  They can get it from independent boutique analysts.  But were better to get information about, say, the upcoming quarter for Cisco than from a Cisco employee visiting as part of an expert network.

securities analysis

I wrote yesterday about the immense amount of information publicly available to a securities analyst.  In the US, companies are required to make extensive SEC filings, in which they report on the competitive environment, the course of their own business and the state of their finances.  Some firms hold annual analysts’ and reporters’ meetings–sometimes lasting several days–in which they try to explain their firms in greater detail.  There are trade shows, brokerage house conferences on various industries and–in many cases–specialized blogs that discuss industries and firms.  Publicly traded suppliers, customers and the firms themselves hold quarterly conference calls, in which they discuss their industries and their results.  The internet allows you to reach competitor firms around the world.

Companies also have investor relations and media departments that provide even more information for those who care to call.  Many times these departments also organize periodic trips to major investment centers to meet with large shareholders and/or with large institutional investors.  The talking points for these trips are scripted in advance.   My experience is that the company representatives attempt to create the impression that questioners in the audience have penetrating insights and are forcing the company to answer tough, and unusual, questions.  And people on my side of the table are usually more than happy to believe that this is true.  But in reality the companies tell basically the same things to everyone.

Still, the idea that anyone who obtains inside information is “infected” by it and becomes a temporary or constructive insider as a result has made profound changes, I think, in the way companies and analysts interact.

Let me offer two examples:

1.  In my early years, I ended up covering a lot of smaller, semi-broken companies that senior analysts didn’t want.  It’t actually a great way to learn.  Anyway, I had been talking regularly for about a year with the CEO of a tiny consumer firm that was flirting with bankruptcy.  This CEO was understandably downbeat and our talks were rather depressing.

Then rumors began to circulate that a Japanese firm was interested in buying the firm at a high price (in reality, anything greater than zero would have been a high price).  I called the CEO a couple of days later to prepare for my next report.  He was very cheerful, didn’t have a care in the world, actually joked his way through my questions.  I didn’t need to ask about the potential takeover.  His whole demeanor told me that the rumors were true.

Did I have inside information?  Twenty years ago, the answer would have been no.  I was just a skilled interviewer drawing inferences from the conversation.  Today, I don’t  know.  I suspect the answer is yes.

2.  I’m in a breakout session with the CFO of a company which has just presented at a brokerage house conference and is answering follow-up questions from analysts in a smaller room.  Someone raises his hand and says that for a number of reasons he thinks this quarter the firm will miss the earnings number it has guided analysts to.  He requests a comment.  Most people know the questioner–or at least can read his name badge.  He comes from a hedge fund that is rumored to be short the company’s stock.

The CFO clears his throat, takes a sip of water and says there’s no reason to think the firm won’t easily make its guidance.

I’ve known the CFO for a few years.  He only clears his throat and sips when he’s getting ready to say something that’s technically true, but is misleading  –in other words, a lie.

Do I have inside information.  Again, years ago the answer would have been no.  Today, I’m not sure.  If this were a private meeting with the CFO, I think it’s likely that I’ve got inside information.  But is a breakout session public disclosure?  Does it make a difference if the session is televised, so everyone can see what the CFO is doing?

My uncertainty changes my behavior.  How?

I probably no longer want a private meeting with top management of a company.  I probably don’t want the company to comment on my earnings estimates, or to give any indication that a non-consensus estimate I may have could be right.

I have to rely more on my independent judgment.  I want to be wary of any interaction with company management.  I don’t want any “help” with my estimates (not that I need any).

This is actually good news for individual investors, because the playing field between them and professional analysts has been leveled significantly.

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