Top 4 Lessons Learned Working as an Equity Research Analyst

The following is a guest post from Simply Safe Dividends. 

My name is Brian Bollinger, and I run the website Simply Safe Dividends.

I have enjoyed following Sabeel’s blog since I discovered it last year, and watching his passive income grow has been fun. Needless to say, I was flattered when Sabeel asked if I would be interested in writing a guest post for his blog. As I thought about what to contribute, I figured some of you might be interested in reading about the main lessons I learned during my career in the investment management industry.

Prior to starting Simply Safe Dividends, I was an equity research analyst at a multi-billion dollar investment firm that actively managed a handful of equity mutual funds. My days were spent reading through annual reports, speaking with management teams, studying the drivers of different industries, and discussing investment ideas with my colleagues. I truly enjoyed almost every aspect of the work. Each day brought a new set of information that needed to be analyzed. There was no shortage of learning opportunities and challenges, and it was exciting to impact investment decisions with millions of dollars on the line.

However, something was missing.

The deeper I got into the industry, the more I began to question the value provided by most active managers. My own investment philosophy had also evolved in a way that no longer aligned with the majority of fund managers out there. Perhaps most importantly, I believed that individual investors were being given the short end of the stick in many ways and deserved better access to data, tools, and research rooted in integrity. Ultimately, I decided to voluntarily resign from the investment management industry.

Starting Simply Safe Dividends allowed me to take on the issues identified above and help individual dividend investors save fees, make better informed decisions, and take tangible steps to get closer to their goals. Working on Simply Safe Dividends is a joy, but I wouldn’t be where I am at today if it weren’t for the lessons I learned from my time spent as an equity research analyst.

Let’s take a closer look at my top four takeaways from working in the industry during my career.

Lesson 1: Even the “Best” Fund Managers are Wrong 40%+ of the Time

Did you know that there are more hedge funds than Taco Bells in the United States? That’s an unbelievable statistic to me. Imagine layering on the thousands of domestic mutual funds that exist. At any given moment, thousands of analysts around the world are likely reviewing the same information on the same stocks in the never-ending quest to identify attractive investment opportunities.

While they will each reach different conclusions about a company’s business quality and fair value, adding up all of their trading actions results in a market that is pretty efficient most of the time. We are no longer in the days Warren Buffett enjoyed 50 years ago where one could flip through ValueLine reports and spot overlooked companies trading at just 50% of the value of their current assets. Information is more accessible and affordable than ever before. No more than 20 years ago, analysts had to call up a company to request that they mail them an annual report to review. Today, that information and much more is available with a click of your mouse. This is one reason why low-cost passive funds are taking market share from active funds.

Beyond the continued narrowing of the information gap, which arguably makes it more challenging for funds to (ethically) gain a competitive advantage, the world is simply a dynamic place. Change is constant, and we are never going to forecast it correctly 100% of the time. To give you one example, take a look at this article from 2006: Why the Apple phone will fail, and fail badly. Many future events are simply too hard to predict. They can impact companies and our everyday lives in ways we can’t even begin to imagine sometimes. Given the competitiveness of the industry and the constantly evolving state of the world, successful investing is not easy for an active fund manager or any of us.

During my career as an equity research analyst, I had the privilege of meeting with a small handful of portfolio managers from firms that I believe do have legitimate skill. These funds have strung together multiple decades of outperformance relative to the market and take an approach uncommon in the industry. One of the funds, for example, would assign less than five companies to a new analyst to research during his or her first year.

Imagine if you worked 60 hours per week studying three of your holdings for an entire year. Perhaps it is information overload, but I would imagine you would know more about that business and industry than practically 99% of all other investors out there. My next point might come as a surprise. Despite the research intensity of these funds, many would tell you that they are still wrong with their stock picks 40% of the time or more. Despite the countless hours of hard work getting to know a company and industry, little can be done about the unexpected variables that crop up. Perhaps more surprisingly, some of these funds told me that the majority of their long-term outperformance has been driven by a small handful of stocks in many cases. At the time of initial investment, the fund managers really couldn’t tell you which of their holdings would go on to be the star performers – that’s how difficult and uncertain investing is!

What can individual investors take away from this? If a fully dedicated team of analysts with decades of experience is still wrong at least 40% of the time and can’t reliably pick which holdings will be the biggest winners, we can’t either. As famous stock trader Jesse Livermore once said, “The stock market is never obvious. It is designed to fool most of the people, most of the time.” The best we can do is implement a consistent investment process focused on the long term and maintain reasonable expectations of what is attainable.

Lesson 2: Patience is Still a Virtue

Have you ever felt like you could complete your work for the day in a matter of hours but instead have to be present in the office from 9:00AM to 5:00PM? You are not alone. In Warren Buffett’s 1989 shareholder letter, he bring up a force he calls “the institutional imperative.” One example he gives is that work expands to fill available time. This is an issue across many industries, and investment management is no exception.

Analysts often feel they are being compensated for activity at many funds. While Warren Buffett’s portfolio of dividend stocks exhibits extremely low turnover, many funds routinely trade in and out of at least half of their positions in a given year (i.e. 50%+ portfolio turnover). With so much noise generated by the financial press, media outlets, and quarterly earnings, it can be hard to resist the urge to do something – especially when portfolio managers feel increasingly pressured to outperform every quarter, which is impossible.

Trading activity is usually the enemy of returns, and anything can happen to a stock over the course of one year or quarter. It is far too short of a time period for business fundamentals and the power of compounding to be reflected. Rather than play the momentum game and be a slave to every piece of news hitting the wire, we need to stay focused on whether we are truly comfortable owning a business for the long term:

“If you don’t feel comfortable owning something for 10 years, then don’t own it for 10 minutes.” – Warren Buffett

Wanting to sell a stock because it has not worked for the last few months is nonsense. Invest in high quality companies and give them enough time (e.g. 5+ years) to continue improving their underlying fundamentals. As individual investors, we do not need to worry about reporting to portfolio managers or issuing quarterly performance reports to clients. We can capitalize on these advantages by remaining patient with our investments and focusing on the long-term investment outlook.

Lesson 3: Do-It-Yourself Investors Save Fees But Face Potentially Riskier Costs

Many of you reading this blog are probably at least somewhat aware of the fees many financial advisors and active managers charge you each year to invest in their funds. Management fees generally range from 0.5% to 1.5% of your assets each year and really add up over time. Unlike many of our other expenses, these fees can be harder to track down. Instead of seeing a charge on your credit card or writing a check to pay management fees, the expense is taken straight out of your account with no action required on your part.

In most cases, I believe it makes more sense for fund investors to buy passive exchange traded funds (ETFs) rather than active funds. Some dividend ETFs have expense ratios less than 0.1%, which is a bargain – especially for smaller investors.

In addition to saving on fees, individual investors who manage their own money like having more control over their investments – no one cares about your nest egg more than you do. While these are two benefits of investing on your own, several new risks can come into play for do-it-yourself investors.

Most importantly, we are vulnerable to making decisions based on emotions. I have received countless emails from dividend investors asking when they should starting buying in to the market. They worry that the market is long in the tooth and don’t want to get burned. In other words, they are trying to do the impossible and time the market to some degree. Many investors were burned during the financial crisis, selling at the bottom in 2008-09 and watching from the sidelines as the market more than doubled over the next few years.

In my opinion, this is where financial advisors and managers should earn their keep. In theory, financial advisors help by preventing some of us from screwing up our financial futures. Their job is to get us properly allocated in assets that are appropriate for our goals and guide the ship through different environments – good or bad. If a financial advisor or fund manager kept you from liquidating your account during the bottom of the financial crisis, they were arguably worth their weight in gold – even despite the fees.

Instead of watching your money sit idly as the market roared back to life, you would have stayed invested and seen your account eventually recover. For many people, this could have meant the difference between retiring in the next five years and having to work for another decade. Investing on our own requires a good deal of financial and emotional risk. We need to be able to stomach stock price volatility and stay the course no matter what our emotions urge us to do. For those with less discipline and patience, continuing to navigate things with a financial advisor and buy funds could be worth the cost if it helps avoid a more severe setback caused by self-inflicted mistakes.

Lesson 4: Confidence is Not Competence

Perhaps one of the biggest traps “professional” and individual investors run into is an emotional one. Being wrong never feels pleasant, but investors are wrong all of the time – it’s inevitable. We tend to overestimate our ability to know things and can quickly become attached to an investment idea. Overconfidence begins to build. After all, we (hopefully) invested some time into researching a stock and have real money committed to the idea. No one wants to lose money.

One of the hardest things to do in investing is admit that our initial thesis was wrong by remaining objective and analyzing new information as it comes in. In fact, determining we were wrong and acting to correct our wrong decision are two key reasons why George Soros believes he has been successful:

“I’m only rich because I know when I’m wrong. I basically have survived by recognizing my mistakes. I very often used to get backaches due to the fact that I was wrong. Whenever you are wrong you have to fight or take flight. When I made the decision, the backache went away.” – George Soros

Excess confidence in our abilities also gets us into trouble when we invest in areas of the market we have no business being in. One of my favorite takeaways from Warren Buffett is his focus on remaining within his circle of competence. He is self-aware enough to know that some industries are too hard even for him to forecast, and he sticks to his guns. Even when the technology bubble was going against him, he refused to step foot into the sector. He was eventually vindicated, but you can only imagine the emotional strain most investors would have felt during that time. Interestingly enough, I believe risk management techniques such as diversification can sometimes result in more risk for a particular investor or portfolio.

Focusing too much on diversification might compel an investor to buy stocks in an industry he has very little familiarity with (e.g. semiconductors) solely because his portfolio “needs” exposure to it. What happens if his semiconductor stocks drop by 20%? He is more likely to make another mistake and panic sell his semiconductor positions since he doesn’t understand them as well.

Of the 10,000+ publicly-traded stocks around the world, I usually tell people that there are probably no more than 200-300 stocks I would ever consider owning in my own portfolio at the right price. If I am being realistic, most companies are too difficult for me to understand well enough to invest money in them for the long term.

There are a number of reasons why this can be the case – the industry is subject to a fast pace of change, the products or services are too complex, the company depends too much on unpredictable macro factors, potential technology changes, and more.

Final Thoughts

Working as an equity research analyst was a great experience that helped open my eyes to the realities of active management and investing in general. By keeping realistic expectations of results that are attainable and remaining self-aware of our flaws, do-it-yourself investors can save fees and have greater control over their investments. However, there should be no delusions about how difficult investing is – even for the small percentage of professionals that appear to have skill. Luck and randomness will always play a role, and the world is constantly changing to impact companies (and our investments) positively and negatively.

What are some of the lessons you have learned going it alone as an individual investor?

 

12 thoughts on “Top 4 Lessons Learned Working as an Equity Research Analyst

  1. Awesome post. I fully agree with you.

    The key problem are clients and their expectations – earn money always and now (if you say you will earn in next month/quarter etc. money are outflowing, if you are outperforming while market is declining it is your fault, if you are growing faster than index it’s client who chose correctly).

    Surely if you have brand like Warren then clients are (maybe) more patient… unique situation.

    Best regards,
    DividendTIME

    • Hi DividendTIME,

      Thanks for your comment. I agree that clients’ expectations create many conflicts. There is always the temptation to chase the hot manager and leave an underperforming fund right before current trends reverse. A constant pressure to outperform over unrealistically short time periods!

      Some managers have the luxury of maintaining a base of longer-term focused clients, but they have usually earned it over the course of several decades (or a lot of wealthy friends and relatives!).

      Best,
      Brian

  2. I havent been investing in wall street long but have always considered myself a DIYer. With that being said from the get go i started reading warren buffet books and teaching myself to invest because in the end, If I make bad decisions I want it to be my fault and not some money manager or fund manager out there who you cant even trust.

    Really glad to see your job helped you pave the way to manage your finances though. Pretty cool!

    • Hi Alexander,

      Thanks for chiming in. Investing certainly isn’t rocket science, but we can be our own enemies if we aren’t careful. I think it’s great to be accountable for our actions and financial future. Keep it up!

      Brian

  3. Thanks for the great guest post, SSD! I’ve been a fan of your site for awhile.

    I agree that investors are their own worst enemies, especially for a fund manager that CAN’T invest their clients’ money for the long term because the client wants to see an absurd increase by next.quarter.

    I also think people have this mental image of what the stock market is SUPPOSED to be that creates self-defeating habits. People believe that the stock market is supposed to be a fast paced gambling house for the ultra rich filled with yelling and complex numbers and fortunes made and lost and it scares people. It scares people away from investing in the first place and it scares people into making bad reactionary decisions.

    Not to sound like a know-it-all wannabe guru, but I think investing isn’t nearly as hard or risky as people think, overall strategy-wise. If you buy high quality businesses for the long term that pay dividends and reinvest those dividends into other high quality dividend payers, your mistakes will be few and far apart. Not that you won’t make ANY, but no one ever lost their family fortune with KO, JNJ,, and PG.

    Thanks for the great article!

    Sincerely,
    ARB–Angry Retail Banker

  4. Hi ARB,

    Always good to hear from you. I agree with everything you said. The key is having patience and realistic expectations of what is attainable. In my view, the stock market is a way to preserve and moderately grow one’s wealth – not to create wealth overnight.

    Best,
    Brian

  5. Dan says:

    I am new to your weekly letter and look forward to your weekly “coaching”. I took over my own 401k and built my own mutual fund with dividend stocks. Always learning and appreciate your advice every week.

  6. Larry says:

    One lesson, or caution, is to not let the braggots on SA (or other investor services, newsletters, blogs, etc) tempt you to deviate from your investment plan. Many people love to tell us how much they are beating the indexes by
    or how much they profited by this or that trade. Whether believable or not, it is dangerous to envy people’s self-proclaimed success. Listen with a jaundiced ear, keep doing only what you know how to do and stay YOUR course.

  7. JBL says:

    Brian, your writings tend to provide balance for me, and this one is no exception. From my perspective, fear is always present in investing. If I am in control of my fear it is my best friend, if not, it is my worst enemy.

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