Career Profile: Wall Street Equity Research Analyst

Want to know what a Equity Research analyst on Wall Street does? Me too. I had the good fortune of interviewing one of these analysts. Check out the interview below:

The Skinny

Title: Equity Research Associate
Length of time in field/profession: 4 years
Location: NYC

Details

Mr. Honcho: So, what do you do for a living?
Wall Street Guy: I work for a brokerage firm where I write research analyzing companies and forecasting stock prices.

Mr. Honcho: You're a stock picker?
Wall Street Guy: Sort of. My company manages assets for high net-worth individuals. I don't actually sell products or manage any client's particular portfolio. Rather, I research individual companies and generate investment ideas and recommendations.

Mr. Honcho: What kind of companies do you research?
Wall Street Guy: Gas utilities and specifically natural gas distribution companies.

Mr. Honcho: Why gas utilities?
Wall Street Guy: I'm interested in the energy sector, especially new developments that will help promote the conservation of natural gas. Energy is an important aspect of our economy, and at the same time, the generation of electricity accounts for 1/3 of our country's greenhouse gas production.

Mr. Honcho: What kind of skills do you need to do your job?
Wall Street Guy: Accounting and finance, particularly an understanding of financial ratios. Also, I read a lot, and careful reasoning skills are important.

Mr. Honcho: What type of education do you have? Is that where you developed the formal skills to become an equity research analyst?
Wall Street Guy: I went to an Ivy League college where I studied economics. College was helpful for developing a certain mindset, getting the background for how the economy and stock market work. For my day-to-day work, it's mainly important to be analytical - both mathematically and verbally.

Mr. Honcho: So, what do you think about the big drop in the stock market this past week?
Wall Street Guy: Well, I lost a lot on my investments, especially because I'm in a China exhange traded fund (FXI).

Mr. Honcho: Was the fall in stock prices justified or was this an aberration?
Wall Street Guy: A significant protion of the financial community thinks that stock prices have been way too high and a correction was necessary and in order. Part of how stocks trade is based on fundamentals and part is based on psychology. The high stock prices we have seen have not been justified by the fundamentals, but the prices stayed high as long as investors were optimistic.

Mr. Honcho: Do you have any predictions moving forward?
Wall Street Guy: My guess is that investors are going to wait for prices to come down further before they're ready to buy. The world economy is currently enjoying healthy growth, and continued growth is forecasted for 2007. I don't expect stock prices in China to return back to levels from before this week for at least several months.

Mr. Honcho: What do you think about the Efficient Markets Hypthosis?
Wall Street Guy: It's nonsense. The general public is on a certain playing level, but then there are the elites who are on a whole other level. The elites are elite in that they have access to all kinds of information that the general public doesn't or if they do, don't know how to use the information.

Mr. Honcho: What kind of information or resources do you have that the general public doesn't?
Wall Street Guy: The average person relies on the news to get their financial information. To be a good investor, you have to have a strong background in accounting and finance. Also, as part of an institution, I have access to all industry publications, which for my coverage area is about a dozen publications. The general public does not have access to these types of publications unless they pay top dollar. At my company, we have access to extensive databases of information that the average individual can't access unless they're willing to pay thousands of dollars a month.

Mr. Honcho: Maybe the average investor like myself doesn't have the research capabilities that you have, but what about the mutual funds that average folks can invest in? By pooling our resources with the mutual funds, don't the mutual funds even out the playing field for average folks?
Wall Street Guy: Maybe, maybe not. Most mutual fund managers are generalists - they know a little about everything.

Mr. Honcho: Why should I invest money with an asset manager or actively-managed mutual fund when I could be putting my money in an index fund or ETF?
Wall Street Guy: For the average investor, you want to go with a passive fund since most actively-managed mutual funds do not beat the market after accounting for expenses.

Mr. Honcho: Ok, last question. What do you think about last year's record Wall Street bonuses?
Wall Street Guy: Well, it reflects the M&A (mergers and acquisitions) boom, which most of my banker colleagues believe will probably continue for a while.

Stocks, Drops and a Fear of Money

Obviously the news of the day (and perhaps moving forward, the weeks to come) is the broad-based sell-off of stocks throughout global financial markets on Tuesday. According to a large swath of the popular press, the consensus culprit appears to be the sudden unexplained drop in the Shanghai and Shenzhen stock market indices exacerbated by technical glitches from Dow Jones and the NYSE. And, just like that, presto, the economy becomes front page news with warnings of doomsday and gloom.

With no obvious sudden macroecomic shock (like 9/11), how does one explain this sudden fear and panic? If the market supposedly is "efficient" and all information is known and reflected in stock prices, why do these sudden gyrations happen if no big external event has happened? I don't have any definitive answers to these questions. If I did, the Honchos would be sitting on a beach somewhere sipping pina coladas. However, it does seem like herd mentality and chrematophobia have taken place. Yes, chrematophobia, or the fear of money. While a 3.5% one-day drop in the Dow is nothing to sniff at, as an isolated event, it's really no big deal. One has to go back to this day to really feel the hurt. If the 3.5% drop is a sign of things to come, an omen for the future, we're probably all in for a world of hurt. But for all the people who've been happily watching their stock returns increase for the past one, two, and more years, all also for no apparent reason other than vague notions of "increased profitability", it's probably good to see a drop here and there to chase out some of the weaker money from the markets.

Rollin' with Random Walk Investing

If you've taken a finance class in the past 10 years or have any interest in investment theory, you'e probably learned or heard about the efficient markets hypothesis. The efficient markets hypothesis essentially says that prices of assets in financial markets reflect all known information about those assets and are thus "efficient" or properly priced. Burton Malkiel's A Random Walk Down Wall Street is perhaps one of the most accessible and readable (i.e. you get to skip all the math and formulas and get right to the conclusions) books about this theory. The following is a copy/paste of UCLA law professor Steven Bainbridge's Amazon review/summary of Malkiel's Random Walk:

Two basic theories are expounded here. First, modern portfolio theory (MPT), which elucidates the relationship between risk and diversification. Because investors are risk averse, they must be paid for bearing risk, which is done through a higher expected rate of return. As such, we speak of a risk premium: the difference in the rate of return paid on a risky investment and the rate of return on a risk-free investment. In the real world, we measure the risk premium associated with a particular investment by subtracting the short-term Treasury bill interest rate from the risky investment's rate of return. The risk premium, however, will only reflect certain risks. MPT differentiates between two types of risk: unsystematic and systematic. Unsystematic risk might be regarded as firm-specific risk: The risk that the CEO will have a heart attack; the risk that the firm's workers will go out on strike; the risk that the plant will burn down. These are all firm-specific risks. Systematic risk might be regarded as market risk: risks that affect all firms to one degree or another: changes in market interest rates; election results; recessions; and so forth. MPT acknowledges that risk and return are related: investors will demand a higher rate of return from riskier investments. In other words, a corporation issuing junk bonds must pay a higher rate of return than a company issuing investment grade bonds. Yet, portfolio theory claims that issuers of securities need not compensate investors for unsystematic risk. In other words, investors will not demand a risk premium to reflect firm-specific risks. Why? There is a mathematical proof, which relates to variance and standard deviation, but Malkiel explains it in a way that is quite intuitive. Investors can eliminate unsystematic risk by diversifying their portfolio. Diversification eliminates unsystematic risk, because things tend to come out in the wash. One firm's plant burns down, but another hit oil. Thus, even though the actual rate of return earned on a particular investment is likely to diverge from the expected return, the actual return on a well-diversified portfolio is less likely to diverge from the expected return. Bottom line? If you hold a nondiversified portfolio (say all Internet stocks), you are bearing risks for which the market will not compensate you. You may do well for a while, but it will eventually catch up to you (as it has recently for tech stocks).

The second pillar of Malkiel's analysis is the efficient capital markets theory (ECMH). The fundamental thesis of the ECMH is that, in an efficient market, current prices always and fully reflect all relevant information about the commodities being traded. In other words, in an efficient market, commodities are never overpriced or underpriced: the current price will be an accurate reflection of the market's consensus as to the commodity's value. Of course, there is no real world condition like this, but the securities markets are widely believed to be close to this ideal. There are three forms of ECMH, each of which has relevance for investors: **Weak form: All information concerning historical prices is fully reflected in the current price. Price changes in securities are serially independent or random. What do I mean by "random"? Suppose the company makes a major oil find. Do I mean that we can't predict whether the stock will go up or down? No: obviously stock prices generally go up on good news and down on bad news. What randomness means is that investors can not profit by using past prices to predict future prices. If the Weak Form of the hypothesis is true, technical analysis (a/k/a charting)-the attempt to predict future prices by looking at the past history of stock prices-can not be a profitable trading strategy over time. And, indeed, empirical studies have demonstrated that securities prices do move randomly and, moreover, have shown that charting is not a long-term profitable trading strategy. ** Semi-Strong Form: Current prices incorporate not only all historical information but also all current public information. As such, investors can not expect to profit from studying available information because the market will have already incorporated the information accurately into the price. As Malkiel demonstrates, this version of the ECMH also has been well established by empirical studies. Implication: if you spend time and effort studying stocks and companies, you are wasting your time. If you pay somebody to do it for you, you are wasting your money. ** Strong Form holds that prices incorporate all information, publicly available or not. This version must be (and is) false, or insider trading would be profitable.

In the last section of RANDOM WALK, Malkiel distills all this theory into an eminently practical life-cycle guide to investing. As one may infer, it has two basic principles. First, diversification. Second, no one systematically earns positive abnormal returns from trading in securities; in other words, over time nobody outperforms the market. Mutual funds may outperform the market in 1 year, but they may falter in another. Once adjustment is made for risks, every reputable empirical study finds that mutual funds generally don't outperform the market over time. Malkiel's recommendation: put your money into no-load passively managed index mutual funds. You will see lots of anonymous reviews of RANDOM WALK claiming Malkiel is wrong. Odds are, most of those folks are have either been misled by the long bull market or, even more likely, are brokers or other market professionals who make a living selling active portfolio management. In sum, buy it, read it, believe it, and practice it.

So, basically, if you believe in Malkiel's analyses as I do, all you technical analysis guys out there looking at double tops, head and shoulders, wedge formations and what not are kidding yourselves. And, so are you fundamental value guys figuring out which P/E's are low. But, what about the Warren Buffets and Peter Lynchs of the world who have proven track records of consistently beating the market? There's no doubt that there are a certain number (a small number, by the way) who have had amazing performances over time - is it a matter of skill and abilities or are these individuals outliers, the guys who are several standard deviations above the mean in the distribution of the universe of investors? With the number of people out there playing the markets, probability theory predicts a certain number of Warren Buffets will make it out of the fray.

So, why do I embrace the Random Walk school of thought? One, because I think the theory is right, and two, it's expedient for me to do so (I understand the latter is not much of a justification). For starters, as smart and talented as I like to think I am (Mrs. Honcho's protestations notwithstanding), there are lots of much smarter folks out there working in finance and trading in the markets who are unable to consistently beat the market. And because I have limited time and resources to devote to research, the chances of me being one of the Warren Buffet multi-standard deviation outliers is about none to none. Sure, there's probably some genius holed up in an apartment in the likes of Brooklyn who has figured out a computer program to calculate and find temporary arbitrage opportunities in the market and make profits from that, but overall it's hard to see how markets aren't efficient. Do you really think Jim Cramer or Money Magazine is providing you information that isn't already known or readily accessible?

So what do the Honchos generally invest in? Index funds (including large, mid and small cap equities as well as exposure in foreign markets - e.g, SPY, QQQ, IWM, EEM) and retirement age-based fund of funds (e.g., VTIVX, VFIFX). Not only can you get a diversified holding of stocks and bonds through these holdings, investing in index funds and fund of funds takes away a lot of the thinking involved in picking individual stocks. This isn't to say that Mr. Honcho doesn't delve in the occasional small-cap stock here and there. Irrational you say? Absolutely. More thoughts on this as well as the first part of Malkiel's analysis (modern portfolio theory) at a later date.

Real Estate: Myths and Exaggerations II

Myth: Buying a home is a great investment.
Reality: Maybe

One of the most common reasons given for buying a home is that owning property is a great investment. The correlations don't lie - the average net worth of a homeowner in our country is much higher than the average net worth of a renter. But, is correlation equal to causation here? Should we put all of our money into real estate?

Let's compare real estate with another asset class - stocks. According the U.S. Census Bureau, in 1990, the median price of a home in the U.S. was $122,900. By 2006, the median price was $245,300, an impressive gain of $122,400 or 99.6%. Contrast that with the S&P 500, which on January of 1990 was at 329.08 and by June 1, 2006 was at 1285.71. That's a 291% gain. Or put it another way, invest that same $245, 300 in the S&P 500 in January 1990, and your investment would be worth $713,083. What if we go back further in time? Thirty-one years ago in 1976, the median price of a home in the U.S. was $44,200, the equivalent of a 455% gain by 2006. The S&P 500 was at 90.9 on January 1, 1976. That's a 1314% gain.

Some of you will say - hey, wait a minute. Most homeowners didn't pay for their homes outright - most people make a down payment and take out a mortgage. When housing prices increase, their return on investment is much higher because they're using the bank's money to fund the purchase of the home. If I put a $10,000 down payment on a $100,000 home and the price of my home appreciates to $150,000, I've made $50K just off a $10K investment. Those suckers who invested in stock had to spend $100K of his (because suckers are usually men) own money to buy the stock, and when the value of his holdings go to $150K, he's made the same $50K but had to put up $100K to get there! Perhaps, but how is this really different than buying stock on margin?

Others of you will say - hey, what about all those people who made a killing off of real estate in California, Boston, Manhattan and DC - even better than stock market index returns? More power to anyone who can figure out which markets are hot and can time the market (or maybe they're just lucky that they picked the *right* place to live), but if you've really got those Nostradamus skills, why not use those prescient powers and pick some great stocks (and let me know your picks, please). Sure, you could have doubled, tripled, quadrupled or quintupled your money in your Bay Area condo over the past ten years, but you also could have put your money in Yahoo ten years ago and 20x your investment.