February 2020 IssueLong scroll reading

The Quality of Research

By Edward A. Studzinski

“Until life goes out

Memory will not vanish

But grow stronger

Day by day.”


Right after the end of the year, I was speaking with a friend who is a senior portfolio manager at a private, employee-owned, independent investment firm in New York, with approximately $450B in assets under management. As such they are not beholden to either public shareholders (and quarterly earnings) or a parent entity off in some other part of the world, with different and often conflicting priorities. In that conversation, I was grousing about what I saw as a marked deterioration in the quality of buy side investment research. This is driven by a generational shift to analysts who often feel they can learn all they need to know about a business or industry remotely. They do this by accessing information on their Bloomberg terminals as well as listening to company presentations on the internet or through conference calls.

Some of this I blamed on the desire of corporations to limit and control access to executives for reasons of time management. Moreover, there are also the twin requirements of governance and compliance with securities laws such as Regulation FD. And lastly, there is the huge increase in investment personnel seeking access for their research, either as shareholders, or alternatively, as prospective shareholders.

There is also the difficulty of gaining access to the desired individuals in senior management, since investment or analyst days tend to be held in locations such as Boston, New York City, or Los Angeles. Attendance at a day-long set of presentations and meetings often requires an additional two days of travel if one is not making use of private planes and the like. This is appreciated by anyone who has suffered through travel to New York recently, as New York City airports try to rise above being compared unfavorably to the Third World.

And finally, some of it is attributable to the hubris of investment managers. As a group, they often think there is little value in using their time for direct one-on-one contact with the chief executive officer or chief financial officer of a corporation at his headquarters. Alternatively, they often feel there is no value to sitting through a highly scripted set of presentations at an analyst day.

My friend disabused me of my prejudices quickly, as at his firm, analysts were still willing to travel and seek out meetings AT companies. Companies when they were coming to New York often called indicating that they would like to come into his firm’s offices and visit, either with current or potential shareholders. And finally, sometimes the analysts limited themselves to performing their due diligence remotely, which allows them to filter out both white noise and extraneous distractions. At day’s end, it came down to what methodology worked best for helping an analyst to obtain an understanding of a business or industry that gave a competitive edge to the firm and its investor clients.

I have another friend who has a much smaller shop and set of clients. But he also has more clearly defined and limited his circle of competency. This is a driving force in making him want to know more about his companies and their competitors in his tightly limited universe than others. And usually he is highly successful in that. But it requires constant discipline and focus. If there is an investor analyst day being given by an investment or industry he is interested in, he will arrive at the continental breakfast before anyone else. He will have previously identified the members of management that he is interested in meeting or speaking with. And over the course of that breakfast and on through the day he will be glued to the people he is interested in meeting and getting to know. This often causes a corollary as scuttlebutt, insights and snippets of information that don’t make their way into the Q&A for the masses. As a result of his constant striving for the informational edge, he has achieved superb long-term results for his clients. And since it is his firm and he is also beholden to no one, he gets to do things his way, making his fees all in all quite reasonable.

So how do you, as an investor, figure out whether the investment research methodology at a firm or fund is one you are comfortable with? Like many things, it’s not easy to get your head around. You can ask the question, but generally the marketing people at the custodian are going to give you the prospectus answer. How things are really done is more difficult to suss out. And while people will not necessarily lie, you won’t be able to determine that what they say they do isn’t what really is going on.

Probably the most valuable question you can ask is how the analysts are compensated. Some firms look at how many new ideas an analyst comes up with over a fiscal year, how many of them are invested in for clients (with invested asset totals), and what is the performance over the measurement period. What should follow is what is an appropriate measurement period for analyst’s universe? I am familiar with one firm where the organization’s “Guru” insisted that three years was adequate to know the good analysts from the bad. Humorously, a new research director was named and had the numbers redone but for longer periods of time. The four-year numbers almost totally reversed who was at the top and bottom from the three-year performance calculations. And for longer periods, the returns, as with fund returns, tended to smooth out with some degree of stability. Sadly the “Guru” refused to accept what the numbers showed. The resulting toxic environment caused the loss to the firm of two of its most talented thought leaders, an irreplaceable drain of intellectual capital. Those two individuals, tiring of the intellectual dishonesty and pre-vetting of ideas, went off to chart their own courses and are flourishing.

One of the most thoughtful analyses of this issue that I have seen was an interview in the “Graham and Doddsville Newsletter” of Columbia Business School, which in the Winter 2018 issue had an interview with C.T. Fitzpatrick of Vulcan Value Investors. Fitzpatrick indicated that while the focus of his team’s analysis is quantitative, the thing they spend the most time on and where they feel they add value is on the qualitative aspects of valuation. Specifically, they are looking for companies that have a sustainable margin of safety, that they would feel comfortable owning for five years if the public markets were closed. To that end, they have a universe of approximately five hundred names that are followed that meet their criteria. All names are not invested in currently, especially as the discount to valuation needed to purchase is not there. But because the businesses have the criteria they search for, they are all followed. He indicated that analysts are rewarded for adding names to that universe, and doubly rewarded for removing names from that universe. But no one is rewarded for following companies that are currently owned, as there is group involvement in looking at the companies. Someone who is following a company that is owned (maintenance coverage) is not going to be rewarded just for being around when the discount widened to the point where it could be bought.


Choppy Markets or Black Swans

The shift from active managers to passive was already making life interesting in the investment world.

The concern about coronavirus from China and its impact on economies and countries is an unknowable, no matter what the investment style. In the year-end Barron’s Roundtable interviews, when James Anderson of Baillie Gifford (another independent, employee-owned investment firm in Scotland, again beholden to no one) was asked what in his forecasts he saw for 2020, he said: “One of the main reasons, if not THE main reason, that active managers have struggled is because they ask these types of questions, with unknowable answers, where they have a very low probability of being right, and a low connection to the stock markets. It would be better for us all to concentrate on the underlying structural changes in the economy.”

He went on to say that he was optimistic, as over the next ten years, disruptive activity will accelerate, presenting great investment opportunities in equities.

We can’t know what will happen with coronavirus. But one would be better advised to think about it as a disruptive activity, like certain aspects of technology, and be prepared to seek out and take advantage of opportunities as they arise. Burying one’s head in the sand is not an investment strategy. Put differently, as Warren Buffett has often said, where others are fleeing, look at and examine whether it is where you should be looking to invest. But not everyone has the constitutional and intellectual makeup to run towards the fire, rather than away from it.

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.