Wednesday, March 25, 2015

Dalal Street (or Wall Street) Research coverage: Bait for the sharks

We have already learnt in the article about why it might be best to stay away from IPOs that IPOs are a massive section of a bank’s fees. Now let’s think about why a client picks a bank?

One of the principal agent problems that an investment bank has is that they typically have a research coverage team that is not explicitly paid for by anyone. Their trading clients (typically mutual funds, hedge funds, insurance companies, portfolio management companies, etc.) use the research to help them make investment decisions. Now the principal agent problem comes in where the IPO or secondary offering side of the business is pitching to raise capital for a company. At this point do you believe it is easy for the bank to give a negative rating to the stock of this company?

I have never seen this in action but typically I find it very hard to believe that the investment research team of a bank can remain objective with their research given the volume of pitching being done by its banking arm. And the principal agent problem is not just with the companies that are already or become the bank’s clients, but with even those that the bank is constantly trying to woo. As I have mentioned several times before the differentiation between banks of similar scale is very slim and business is won and lost on soft factors – relationships, perception and the like. You never know the pressures faced by the analyst whilst writing the report.

Instead of reading the research reports it is probably better to read the information provided by the company. The information that a public company puts out via annual reports, quarterly updates, presentations, and websites is typically far more than any investor can possibly read. If you have the tenacity to read all that for the past 10 years then your time is probably best spent in talking to customers and suppliers to learn about the industry prospects. Very few people actually do this level research - and several very successful value based portfolio managers do.

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