How to Read an Equity Research Report

By Derek On December 8, 2011 Under Post

“In theory there is no difference between theory and practice. In practice there is.”  – Yogi Berra

Reading equity research is a large part of the day for equity sales, buy side analysts and fund managers. Research, in the industry, is often referred to as “product.” Big banks have dozens, if not a hundred or more research reports being published every day and the bigger the operation, the more the product. As a sales person you will be flooded with “product” most days and your effectiveness (and how you get paid as a result) will, in large part, be determined by how you promote the research to clients and get orders on the back of it. This is called “broking the story.”

When I get to work bright and early and happy, that day’s research often lands with an ominous “thump” on my desk. I can judge the amount of work ahead of me by the decibel level at moment of impact but it can be as much as several hundred pages long. Cutting through the fat with a chainsaw and getting to the meat is what it is all about. You will not have time to read it all. And trust me, you will not want to. In the beginning, as we said earlier, learning the business is like drinking out of a fire hose: you should be reading constantly. Take the research home with you and read it completely there in the safety of your living room. At first, you will have to read a report several times to figure it out. Don’t worry Grasshopper, like catching flies in midair with chopsticks, it gets easier with practice. After two decades of burning through “product,” I can with a glance tell whether the research is relevant or of any value whatsoever to a client. It isn’t magic but there is a process.

Your Ticket to Ride

I am thinking of setting aside a section of the website that is purely instructional in nature. This section will contain real life examples of how to read an equity research report and how to broke an equity research report. I will make this part of the website password protected so I can gauge the interest level here. To access these lessons and examples you just have to input your email address. It’s free and your email is your ticket to ride.

There is no perfect product and I will not withhold criticism if warranted. However, in order to protect the innocent, I have blotted out all references to the analyst who wrote the report and where they work.

Please note: these reports are not to be taken out of context as investment advice. They are no such thing. Research reports here are used for educational and demonstration purposes only.

Let’s take a look at our first report, page one:

The front page is about all most clients read, if they read it at all. Your job as a sales person is to highlight the research to the client and make sure they at least give it a passing glance. If you think on the sales desk you get a lot of research, multiply that flow by ten or twenty times for the client. Each day. Much like garbage emails and garbage voicemails, clients scan research as quickly as they can to determine if the HAVE to read it at all. The thicker the report the more likely it will be used as a doorstop or something to put a potted plant on. And some research is just so bad that it is suitable for wrapping fish and not much else. The front page is critical and must contain everything important with something enticing to get the client to read more.

Detailed supporting arguments for the views presented on the front page are found inside the report with the financial statements and estimates at the end. Finally, to keep the lawyers in business (they have house payments too) several pages of deadly dry legal prose will follow each report, basically claiming, “We don’t know what will happen out there and we may have got it all wrong, we may not even know what we are talking about. Therefore, we refuse to be held accountable for anything we say or write.” Real confidence instilling stuff. This is particularly bad with the US bulge bracket firms. I have on many occasions seen an update on a company written by an analyst that is only a few lines long – followed by three or more pages of turgid legal verbiage, reminding me of a small goldfish trailing a long turd.

The Sauce:

Here is my secret sauce, my sure-fire way of getting through an equity research report and beating it, torturing it until it screams and makes you money.

First: Compal Electronics (2324 TT). This is the company name and the ticker so you can look it up on Bloomberg or other like services for charts and more data. Before you go any further, always ask yourself this question: DOES ANYBODY CARE? Do any of the clients you speak to actually hold this stock? Do they hold competitor stocks? Those that do go to the top of the list of who you call first. After them follow the clients who are active in the space and whom may have asked you about this company in the past. Given the fact the company is a Taiwan mid-cap, it is unlikely other clients would give the proverbial rodent’s behind: don’t waste their time with it!

Second: What is the “take-away” message? Is it a new initiation of coverage, is it an upgrade or downgrade, or is it just an earnings preview or review? In this case, the analyst looks at just announced disappointing earnings and reaffirms his “Reduce” call. This is his recommendation on the stock. Basically, there are three positions to take on a stock: Buy, Sell and Hold.

TIP:

To be brutally honest, most stocks really should be “Buy” or “Sell,” only. As a senior client asked me once when I was green, “This is a “Hold”, you say? How long should I “Hold” it for?” Again, large IBs may have several shades of gray on their recommendation scale, such as “Overweight,” “Underweight,” “Strong Overweight,” etc. These are just fudges to preserve the banking relationship with the corporate. As far as your investing clients are concerned a stock is a “Buy” or a “Sell.” Simple.

Let’s take this step by step.

1)      The title of the report is always supposed to be catchy and enticing. I am not sure this qualifies but at least it gets the message across: the company is in trouble. Next, the text highlighted in yellow is the meat of the report. The company just cut guidance for full year notebook shipments.

TIP:

Everyone now knows this. We have no informational advantage here. What we do with this information is where we will or will not add value for the client. The analyst reminds clients he foresaw this scenario in an earlier report. This builds his credibility with clients and hopefully means they will listen to him now as his other predictions may likely be as accurate as well. Don’t call clients with “news” that you see on Bloomberg, either. They have BBG terminals that they pay good money for. They won’t pay money for you to read off the terminal to them.

2)      The result of the meat is no change to our negative view on the stock. Full stop.

3)      Here we get into the numbers; reported and those forecast by the analyst. The letter “E” that comes after the year means “Estimated.” Since we are dealing with a tech stock in an emerging market we need to look at GROWTH. Is there any? The answer can be found looking at the line “EPS growth” where we see this year earnings per share are forecast to fall 42.5% compared this year and “grow” only 2.8% next year. Pathetic.

What about valuations? Never forget valuations. It can be the best story in the world but if a stock is at 50 times PE then you are too late. Compal trades at just under 10X and they are seeing a massive fall in earnings this year over last year. Plus, next year there is hardly any forecast growth. From a valuation point of view this stock is like Jennifer Anniston without makeup: not attractive.

Is there anything else that stands out? Why, yes. Look at that dividend yield: 8.5%! That is massive. Now we see why the stock is trading at 10 times and not 7 times. It has dividend support. Next question: is the support sustainable? Does the company have the cash? Look at the net debt/equity level: Yes, they are net cash. A negative percentage here means a positive number. This may be a bit confusing but think about it, if you have negative debt that is a good thing, you have cash. Yes, they can pay the dividend out this year and next.

Let’s look at the bottom half of the front page. (If this is hard to read, print it out for more clarity).

  1. Check the market cap – how big is this stock? With a market cap of around US$5bn it is borderline mid-cap range. What about liquidity? If a stock trades less than “a buck a day” (less than US$1 mn) it isn’t liquid and big clients won’t touch it. Lenovo trades almost “ten bucks a day” so liquidity here is ample for most clients.
  2. What happened to the last sentence? Again, fire that editor.

Given the current operating environment, at this level Compal is at best, “dead money,” and really just a dividend play. In a nutshell, that is all you need to know.

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