Sunday, August 09, 2009

Buy Side Vs Sell Side Analysts

For those not in the industry, the terminologies may be confusing. Buy side analysts refer to the analysts working within a fund management firm, generating reports, analysis and recommendation for their own portfolio managers or strategy sessions. Sell side analysts are those at brokerages trying to generate ideas on buys and sells to clients. An example of a buy side analysts team (and its a big team) locally would be the analysts at Public Mutual. These recommendations by side analysts, made exclusively for the benefit of the fund that pays for them, are not available to anyone outside the fund. If a fund employs a good analyst, it does not want competing funds to have access to the same advice. A buy-side analyst's success or talent is gauged by the number of profitable recommendations he or she makes to the fund.

The buy-side differs from the sell-side in three main ways: they follow more stocks (30-40), they write very brief reports (generally one or two pages), and their research is only distributed to the fund's managers. Buy-side analysts can cover more stocks than sell-side analysts because they have access to all the sell-side research. They also have the opportunity to attend industry conferences, hosted by sell-side firms. During these conferences, the managements of several companies in a sector present why they are a better investment. After gathering this information, buy-side analysts summarize their case in a brief report that also contains an earnings forecast. These reports are only distributed to the fund's managers.

The sell-side provides research and conferences to the buy-side in the hopes that the buy-side will let them execute the large trades that the funds make when they act on the recommendation provided by the sell-side. Having access to the sell-side's primary research and the ability to attend industry conferences allows the buy-side analyst to follow many more stocks than a sell-side analyst. To compensate the firm for this information, the funds will buy and sell stocks with the brokerage firms that provide the best information.

You would think that a buy side analyst recommendation would perform better than a sell side because the former only has to please one client, while the latter may be "forced" to generate new ideas or do flip-flops in order to generate trades / commissions. The buy side are paid by the fund management house itself, hence just one client to please or piss off. The sell side is paid by the brokers, which means you can be praised or pilloried or pile-driven by many clients of the firm.

In a 2008 study by Boris Groysberg, Paul Healy and Craig Chapman for the CFA Institute in the Financial Analysts Journal Vol. 64, they looked at buy-side and sell-side earnings forecasts from 1997-2004. The conclusion was that buy-side analysts made more optimistic and less accurate forecasts than their counterparts on the sell-side. The performance differences appear to be partially explained by the buy-side firm's greater retential of poorly performing analysts and by differences in the performance benchmarks used to evaluate buy-side and sell-side analysts.

In a new study by professors from Harvard Business School and the University of North Carolina, they found that shares chosen by sell-seide analysts performed more than 3x better than those selected by the buy-side analysts (1997-2004 as well). The findings are a surprise because buy-side forecasters have none of the conflicts with investment banking units like the sell-side.

A probable explanation is that sell-side research is published while buy-side is not. The fact that it circulates spurs competition, comparisons, scrutiny, and maybe even get recognised when "best of awards" come around. It is also fair to assume that buy-side analysts have a much much less of a chance to be fired, retrenched or replaced than sell-side, and for that reason as well sell-side analysts make much more money.

The results were culled from over 12,000 analysts at brokerages and 340 buy-side institutions. Buy-side "buy calls" generate an annual market adjusted return of 2.3% while sell-siders generate an 8.1% return average. This would really beg the question why fund management firms would continue to fund these buy-side research? One main benefit is to cover those stocks that generally do not appear on the radar of the sell-side analysts. Sell-siders can only reasonably cover big stocks as those are the ones that generate the commissions. Buy-side may need to discover more of the smaller companies.

In my view, the sell-side analysts will always know the companies and the senior management of the companies covered better than the buy-side analysts. Now that there is a stricter and hardier Chinese wall between research / sales / investment banking, it will make sell-side research have a bit mor integrity and reliability.

p/s photos: Pevita Pearce


xatomic said...

I think that the fact that sell side research is published makes more people chase the stocks (especially for credible analysts and research houses), and hence the outperformance

Ooi Beng Hooi said...

I fail to understand why the calls made by various analysts are so different.

For example, after released of Public Bank quarterly result, some of the calls made by various analysts:

CIMB: Outperform, target price RM 11.10
AMResearch: Buy, target price RM 10.00
Inter-Pacific: Outperform, target price RM 9.75
Kenanga Research: Buy, target price RM 9.30
OSK: Buy, target price RM 8.60
Mayban Investment Bank: Sell, target price RM 7.60
Credit Suisse: Underperform, target price RM 7.50
UOB KayHian: Hold, target price RM 6.88
Citigroup: Sell, target price RM 5.77

Some have "BUY" calls, some have opposite calls and one have neutral position.

Even though Public Bank is considered a transparent listed company with high disclosure of corporate information compared to others, I am a bit surprised to see such wide range of target price, with the highest one almost double the lowest target price.

How can they be so different?