Confessions of an Independent Analyst
by Douglas Kim
Independent insight published on Smartkarma 10th November 2017
Read more of Douglas’ work by clicking here!
This is a follow-up to my report Independent Research in Asia 2.0. I borrowed the title from a memorable book called Confessions of an Economic Hit Man written by John Perkins. The purpose of this report is to provide a more detailed account of my personal experience as an independent research analyst in the past couple of years as well as the growth of the independent research platforms such as Smartkarma.
I hope to present an honest view of my experience and discuss both the rewards and the challenges of an independent research analyst and third-party research platforms. Many insight providers are likely to have similar struggles and may have asked the same questions that are highlighted in this report.
The global research in a post-Mifid II environment is likely to change dramatically. The clients that read this report may also get an improved understanding of how to better utilize independent research analysts and recognize their limitations as well. In particular, I discuss the following three major issues in detail:
- The Beginning & The Network Effect
- Warren Buffett’s “Knowing Your Circle of Competence” & Key Challenges of Coverage
- What is Most Important?
The Beginning & The Network Effect
More than two years ago, I decided to give it a try as an independent equity research analyst. The job market was tough and with nearly two decades of experience as an equity research analyst, I thought there could be an interesting opportunity as an independent research analyst. After Googling “Asia” and “Independent equity research analyst”, I came across a company with a catchy name called Smartkarma, which provided a third party platform for independent research analysts like myself. After a review process and a chat with Jon Foster, I was allowed to contribute on this platform. My first report on the Smartkarma was about a Korean dairy & baby formula company called Maeil Dairy Industry (005990 KS). Biggest Beneficiary in Korea from China’s Two Children Per Family Policy? I think I spent about 3 weeks on this one report (nearly 40 pages). The initial response was disappointing, with the report getting a relatively low response from the Smartkarma community and its clients.
Nearly two years have passed since then and a few days ago, Smartkarma announced a major breakthrough investment by Sequoia Capital, which I believe is a home run for the company. What did Sequoia Capital see in Smartkarma? Sequoia has funded monster companies such as Apple, Google, Oracle, PayPal, YouTube, Instagram, Yahoo!, and WhatsApp in the past. Sequoia’s investment in Smarkarma is a HUGE thumbs up for independent research in a post-Mifid II environment. Smartkarma’s ability to capitalize on the network effect was probably one of the integral reasons as to why Sequoia Capital invested in this company.
The network effect is simply defined as a phenomenon where a good or service becomes more valuable as more people use it.
Companies such as Google, Instagram, and WhatsApp are prime examples of this network effect. They have built enormous moats capitalizing on this network effect which is difficult to break into by its smaller competitors.
In the global independent research platforms, SeekingAlpha is probably the most well known. However, there have been a lot of questions regarding the overall quality of their contents as well as their content providers, especially from the institutional investors’ points of view. Despite these concerns, SeekingAlpha has built a strong brand name and many investors like to view this website for generating investment ideas. As Smartkarma expands in the US market as well, a key challenge will be trying to compete against established players such as SeekingAlpha.
About a decade ago, I was doing some Korean investments related consulting work for a multi-billion dollar hedge fund called Luxor Capital based in NYC. Here, I was introduced to a website called Value Investors Club, which is widely used in the hedge fund/buy-side community for generating ideas. Unlike SeekingAlpha, the contributors at Value Investors Club are anonymous, which has its pros and cons. Overall, the research generated in Value Investors Club tends to be more on an “institutional” level compared to the ones on SeekingAlpha. Established by a well-known hedge fund manager, Joel Greenblatt, the Value Investors Club’s purpose is not to make money for the website itself, but more for its users (mainly institutional buy-side firms) to generate ideas that are not normally available in regular sell-side research. The Value Investors Club is another example of a website that has benefited from the network effect.
Right now, Smartkarma has a distinct lead in the Asian independent research platform with regards to the network effect (including the overall number of independent research providers). However, as it continues to expand in Europe and North American markets, it will face tough competitive pressures. Nonetheless, Sequoia Capital’s investment in Smartkarma provides a major vote of confidence and capital for the company to continue to successfully break into new markets globally.
Warren Buffett’s “Knowing Your Circle of Competence” & Key Challenges of Coverage
One of Warren Buffett’s favourite maxims is “knowing your circle of competence” and this has direct relevance to independent research analysts as well. Warren Buffett is famous for investing in companies that he understands. He has made investments in companies that he understands very well such as Coca-Cola and American Express. As an independent research analyst, you are “unshackled” to provide research on essentially any company in the world, unlike the traditional sell-side research analyst who typically has “core” coverage in 12-20 companies.
But who came up with the “industry rule” that the traditional sell-side research analyst needs to cover 12-20 companies and is this optimal? The equity research industry has its roots in the developed US/European markets. The need to maintain quarterly earnings updates is one of the key reasons why a typical senior equity research analyst has 12-20 companies under coverage. Think about it. Many of these companies have quarterly announcements in a similar time frame. Plus, there is a time limit as to how well an analyst can update an excel model and write about a company during the earnings seasons. The counter-party buy-side analyst (who works for a portfolio manager) typically has about 50-70 companies under “core” coverage.
Breadth vs. Focus Coverage – One of the goals of the traditional sell-side analysts is to dominate a few, core coverage stocks. For example, a few years back when I was a sell-side analyst covering renewable energy sector in Korea, one of the core stocks under my coverage was Oci Co Ltd (010060 KS), a leading producer of polysilicon. It was my job to better understand this company, write more research, and call more clients on this name than any other analyst on the Street. The salesforce always kept a record of how much trading was done on this name (and all other companies under my coverage) on a monthly basis.
This business structure is similar for the other sell-side analysts that cover stocks like Apple, Samsung Electronics, or Alibaba. Plus, there were long overseas marketing trips throughout the year. It is fair to say that about one-third of my time was spent on marketing/speaking with clients and the other two-thirds on writing research reports, updating models, and thinking about the changing industry dynamics. The amount of marketing versus writing reports may differ for each sell-side analyst but most of the sell-side analysts typically spend an awful lot of time on marketing and speaking with clients.
One of the benefits of the traditional sell-side analyst model is the fact that the biggest long-only funds sometimes have active engagement with the sell-side analysts for the stocks that they are interested in with regards to discussing key earnings estimates assumptions, for example. Analysts with solid track record of consistently forecasting earnings with logical assumptions tend to receive higher points from major long-only investors.
On the other hand, this advantage of being able to “dominate” a few stocks could work against the analyst, especially during a major downcycle in a particular industry. In addition, the extreme focus on a particular industry could also mean that this sell-side analyst maybe less aware of how the entire stock market, as well as other companies in different industries, are faring. This is where experienced strategist, salesperson, and equity traders can really help to bring incremental value to the buy-side clients.
Given this background, one of the major dilemmas for the independent research analysts is to pick the companies and industries that they want to cover and this goes back to Warren Buffett’s emphasis on “circle of competence.”
In the stock market, there are so many sectors to cover. But it is almost impossible to understand in depth so many different industries at the same time. Plus, many analysts may not have had previous exposure to certain industries. For example, Warren Buffett tends not to invest in biotech stocks. This does not mean there aren’t great biotech investments out there. In Korea, biotech stocks have been on a tear and they have been some of the best investments in the past several months.
With nearly two years of experience in independent research, I had to do some “soul searching” in terms of additional coverage. For example, there have been several interesting IPOs in Korea related to the biotech sector in 2017. After much thought, I decided against writing about them, despite the temptation to do so, mainly because writing research about Korean biotech stocks would mean losing some focus on my existing coverage.
In addition, the top three stocks including Samsung Electronics Co Ltd (005930 KS), SK Hynix Inc (000660 KS), and Hyundai Motor Co (005380 KS) represent nearly one-third of the entire Korean Stock Market in terms of market cap and they are well covered by existing sell-side analysts. As a result, I have concluded that it is very difficult for me to provide any differentiated view on these names and I have not written about these companies in-depth. Overall, I have tried to keep my coverage “limited” to IPOs, M&As, spin-offs, as well as on existing listed stocks related to the Korean consumer, telecom/Internet/games, industrial, rechargeable batteries, and special situations.
Challenges of Market Cap – There are many diverse investors with different needs for research on large vs. small/medium sized companies. Post-Mifid II, the low-tiered investment banks are likely to face extreme competitive pressure from the bulge bracket firms and independent research providers. As these low-tiered investment banks further downsize their research operations, their ability to cover mid-small caps will be further hampered and in this space, the independent research firms and research platforms such as Smartkarma have a chance to flourish.
In the past couple of years, I have found that clients typically show greater interests in IPOs of companies with market cap of more than US$300 to US$500 million. Personally, I have found that there are many interesting IPOs in Korea less than this market cap range but have tried to put a floor limit on trying to write research on companies with at least US$100 million in market cap.
Typically, writing about the biggest companies in the world such as Alibaba, Apple, and Tencent tend to generate more interest than companies with less than US$300 million in market cap but again there is a trade-off in being able to differentiate one’s research for companies that are not well covered. The insight providers at Smartkarma are consistently posed with this trade-off in research (higher market cap stocks which may generate more interest vs. differentiated research in writing about “undiscovered” investment plays).
Challenges of Country vs. Sector Coverage – There are great benefits to having a sector coverage (for example in banking or telecom/Internet) for numerous companies across multiple countries in Asia. Numerous independent research providers have adopted this approach. However, one of the difficulties of taking this approach is that it may require additional capital (for example, hiring additional help for different languages).
For example, Japan and Korea are two vastly different markets and require specific language skills to cover companies adequately. For many independent research analysts in Asia, it may be easier to cover companies on a country-specific basis, given the capital constraints of many smaller independent research firms. As a result, the traditional sell-side approach to covering many companies on a sector basis may provide some competitive advantage for now.
Cooperation among insight providers – This is one area where there is potentially a super potential for independent research platforms such as Smartkarma. There are so many opportunities to interact with various insight providers and try to create innovative joint research products.
For example, one of hottest markets in the world right now is Vietnam. Plus, Korea is one of the biggest foreign direct investors in Vietnam. Given the strong investors’ interests in Vietnam coupled with the fact that Vietnam possesses many of the attributes that South Korea had about 30 years ago, I thought that a joint “Vietnam-South Korea” research report would be a good idea and contacted Vietnam & Frontier Markets specialist Dylan Waller to write joint reports involving Vietnam and South Korea, which were well-received.
- Vietnam Vs. Korea (A Tale of Two Countries: 20 Investment Themes for the Next Decade) – Part I
- Vietnam Vs. Korea (A Tale of Two Countries: 20 Investment Themes for the Next Decade) – Part II
I also noticed a research product produced by Angus Mackintosh called The Week That Was in Asean@Smartkarma. I thought to myself, “Why not replicate such a product for the North Asian market involving Japan and South Korea?” So I contacted Travis Lundy, Mio Kato, CFA, and Sanghyun Park to see if we could create a similar product and we all agreed that it was a good idea so we started a weekly for the North Asian market a few months back. After a while, I noticed that there was a regular weekly called The Week that Was in Greater China@Smartkarma written on a rotating basis among Scott Laprise/ 乐天虎, Valerie Law, CFA, Ke Yan, CFA, FRM, and Daniel Hellberg.
In early 2017, I also started to read reports on the Smartkarma platform written by Howard J Klein who is an industry veteran in the gaming industry. In writing my reports about the Korean gaming industry, Howard provided valuable inputs that helped to improve the overall quality of the reports.
In addition, I have noticed that two insight providers including Angus Mackintosh and Nicolas Van Broekhoven actually have joined forces to create a firm called CrossAsean Research a few months back, capitalizing on their experience in covering the Southeast Asian stocks.
These examples are just tip of the iceberg. As Smartkarma continues to expand globally and increases its network effect, there are likely to be many ways that the insight providers could share ideas and expertise to create joint reports that add real value to the buy-side clients.
Knowing Your Strengths and Weaknesses – At the core of Warren Buffett’s “circle of competence” also includes knowing your strengths and weaknesses in terms of skill sets. For research analysts, there are several important skill sets/experiences that are required which include 1) analyzing a given industry/company (including building models & making recommendations), 2) writing in a logical, clear manner, 3) communicating verbally/marketing, and 4) years of experience covering a specific industry/playing a key role in taking a company in overseas roadshows/company visits.
Personally, I believe I have an “above-average” skills in analyzing a company, making recommendations, and writing in a clear, logical manner. However, I am “mediocre” in verbal skills and making presentations. Being in this industry for many years, I have seen some other analysts making wonderful presentations to clients that were quite “awesome.”
For independent research analysts with these “awesome” verbal communication and presentation skills, this actually poses a major dilemma. Working as independent research analysts may mean that they may have a lot fewer direct face-to-face meetings with buy-side clients initially as compared to when they were at traditional sell-side firms. As a result, they may be disheartened a bit since they may not be maximizing their strongest skill sets. In the long-run, as the demand for independent research increases, there will be greater opportunities for one-on-one meetings with clients. However, for now, the demand for one-on-one meetings with independent research analysts is relatively low compared to the traditional sell-side firms.
Knowing Your Client and Who Reads Your Research – For nearly two decades, I did not really know who read my research, until Smartkarma! When I was working in the sell-side, I wrote research which was distributed to the buy-side clients in a PDF format. This has been the industry standard for nearly 20 years since the adoption of the Internet and email. The sales team would occasionally tell me that a few clients liked/disagreed with my reports. There were very low visibility in terms of who actually read my reports. Having also worked in the buy-side, there is simply not enough time in a day to read all the reports. I believe I took a look at perhaps 5-10% of the reports coming in my email, and this is probably on the high side for the majority of the buy-side! According to a recent Reuters article, it notes that less than 1% of all research produced by the top 15 global investment banks are read by investors. http://www.reuters.com/article/us-markets-research/online-competitors-take-on-global-banks-in-securities-research-shake-up-idUSKBN16Z0L5
Smartkarma’s functionality of allowing the insight providers to know what clients clicked on one’s report will likely be the industry standard in the coming years. In the past couple of years, I have noticed the clients that regularly click on my notes but also the ones that no longer read my reports!
What is Most Important?
Having worked many years on the sell-side as well as an independent research analyst in the past two years, I realize that there are clear differences in the NUMBER ONE PRIORITY as a research analyst on these two different platforms. As a sell-side research analyst, the number one most important thing was quite clear – which was to get ranked by the biggest global buy-side firms including Capital, Blackrock, Allianz, JP Morgan, and Fidelity. The amount of bonus (or lack of bonus) was largely determined by whether you can get ranked by these Tier-1 firms.
However, my priority as an independent research analyst has changed. My number one priority as an independent research analyst is to generate great investment ideas. There is no longer any pressure to get ranked by these Tier-1 firms. However, there is a different kind of pressure, which is to think and write about great investment ideas.
In addition to the rankings by the Tier-1 buy-side firms, the annual Institutional Investors (II) polls, have been highly important to the sell-side analysts. In the post-Mifid II environment, it remains to be seen how much importance II polls will continue to be. As the major investment banks adopt research platforms that are less PDF dependent but with a greater transparency of which clients are reading what reports (similar to the Smartkarma system), this should improve the ability to have a more data-based system to better understand what reports the clients are reading. As a result, the “beauty contest” based II polls are likely to be de-emphasized and data analytics based system will increasingly be preferred in determining the “value” of investment research produced by both independent and traditional sell-side research analysts in the coming years.
Confessions of an Independent Analyst
by Douglas Kim
Independent insight published on Smartkarma 10th November 2017
Read more of Douglas’ work by clicking here!
