The best analysts like to talk about their work, but always question their assumptions, says Nimalan Govender, senior investment analyst, van Eyk Research.
Why does van Eyk place so much emphasis on having a good investment process when evaluating fund managers? A major part of the reason is that a superior investment process will give the manager the sense of conviction they need to stay the course in their chosen investments and resist the temptation to change direction if the market appears to be going against them in the short term or if there are more superficially attractive opportunities elsewhere.
Managers who do not focus as stringently on proper research methodologies are also likely to have smaller active stock weightings, as they hope to limit the impact of their mistakes. So their capacity to deliver alpha (above the market returns) to investors is limited from the very beginning by their own strategy. These managers often battle to preserve capital and are ultimately breaching their fiduciary duty to investors in their fund.
van Eyk’s recently released International Equity Review 2013, in which we considered 55 managers and awarded four AA ratings, gives a good insight into how we find the best in the industry.
Highly rated managers in this review took an outstanding level of pride in their research effort, which is usually a very promising sign. They undertake stringent due diligence on the stocks they cover. Discussing investment theses with these analysts can often be the highlight of our ratings review meetings.
They can convey their investment thesis in a clear, concise manner and when drilled for details on specific areas (like accounting methodologies, valuation assumptions, revenue and cost drivers and cash flow generation), they are able to support and validate their forecasts with hard data. At the same time, they maintain a healthy dose of scepticism and awareness of the risks around their forecasts.
Analysts have various ways of developing their understanding of a company. The first step often begins with an in depth study of the company’s reported results and annual financial statements. The top analysts we met were able to spot areas of concern in a company’s numbers rather quickly and would investigate further. Many of these analysts had a higher level of intuition or “gut feel” than their peers about a stock.
They were also able to overcome common afflictions among analysts (and the human race in general): cognitive bias and cognitive dissonance. Cognitive dissonance is defined as the feeling of discomfort felt when a person holds two conflicting beliefs at the same time.
A classic example of this is when negative economic data impacts an analyst’s preferred stock. Instead of rationalising the two views, the analyst might water down or ignore the new information as it jeopardises their view on the stock. The better analysts, in contrast, are able to overcome this tendency by maintaining a thorough and objective analytical process and trying to set aside any preconceptions they might have on whether a stock is a suitable investment.
All the investment analysts at van Eyk have had a number of years exposed to both the “buy” and “sell” side of the investment industry. This makes it somewhat easier to gauge if an analyst has justification for his or her position or whether they have fallen hopelessly in love with a stock.
The top analysts in the International Equities Review frequently provided numbers, statistics and unique insights that had not been voiced by their peers and for that reason their forecasts often differed as well. They could also show exactly how these were cross checked and validated.
The final stage in assessing a stock is developing a financial model, essentially a mathematical model that allows an analyst to tweak various parameters and see how they will affect things like the company’s revenue and share price.
Some analysts prefer modelling the company down to the minutest detail, while others prefer to have less complex models. While models are important, analysts also must have the knowledge and dexterity to be able to quickly update the variables in the model when there is new information so they can quickly see the impact on valuations and their overarching investment case. A model that requires a long time to update leaves the analyst at a big disadvantage to their peers and the market in general.
In fact, top analysts tend to have rather simpler models that cover only the key earnings, cash and valuation drivers of the firm. Relying too heavily on models can show a lack of experience. Highly-rated managers are often those who invest heavily in their IT infrastructure to ease the burden on analysts of financial modelling.
This allows the analyst to spend more time questioning the validity of the assumptions that go into their model, rather than filling in cells on an Excel spreadsheet with the details of a company’s latest financial statement.
