Many people think about doing equity research at the outset because it is typically a finance-focused career; for example, spreadsheets, valuation models, and stock recommendations. These activities do form part of the equity research role, but they represent just the beginning of what equity research provides people who do it. More than that, equity research is a very strong training ground for thinking about business from multiple perspectives—the way in which an organization operates, competes, grows, and captures value. People working in equity research for extended periods of time analyzing companies develop a mindset greater than markets and stock prices. They develop a mindset that allows them to think like business owners, strategists, and decision-makers.
This article will discuss the fundamental teaching capabilities of equity research and how equity research helps develop all the different types of skills, perspectives, and mental infrastructures and frameworks through which equity researchers think about companies and business. It will also discuss why equity research lessons are applicable across multiple industries and career fields.
Understanding a business from the Ground up
Equity research teaches the most fundamental understanding of a business, looking at it from a holistic point of view. Headline numbers, such as revenue growth and profit margins, may not give the full picture of how a business makes money, so an equity analyst must have a comprehensive understanding of a company’s revenue-generating processes.
Analysts need to understand the following:
· Company Products/Services. Who are their customers, who is buying the products or using the services? What are the end markets that the company serves?
· The value proposition or the value that the company offers to its customers. What does the customer perceive as the value of the product or service?
· The cost structure (fixed vs variable) of the company.
· Revenue Drivers. What drives revenue? Is it through volume (product or service sales) or pricing power? How will that change in the future?
Through the continuous analysis of these components over time, equity analysts develop the habit of breaking down all businesses into their core components. They develop the skill of asking critical questions, such as:
- What problems does this company solve for its customers?
- Why do customers buy from this company versus other companies?
- Where does pricing power come from?
- What are the major levers that management can use to increase the performance of the company?
The equity analyst’s way of evaluating how a business (whether public or private) operates is similar to how founders and CEOs view their own businesses. Equity research trains individuals to look at businesses as living systems versus abstract financial entities.
Thinking in Terms of Business Model
When a research analyst looks at equity, he/she /they must be increasingly aware of the intricacies of the various types of business models that exist today. All businesses operate under a different set of economic principles.Therefore, many times over, when a research analyst reviews a company’s financial statements and compares it to what they know about the company’s type of business model, they tend to see common themes or similarities.
Research analysts start to recognize specific patterns in those similarities:
- High level ($) of fixed cost versus low fixed cost (High/Low): Operating Leverage/Scalability;
- High level of recurring revenue versus high level of transactional revenue;
- Capital intensive versus Asset Light.
Ultimately, as a result of analyzing and comparing to each other the different types of business
Learning Industry and Competitive Dynamics
No one Operating Business is alone. In the process of Equity Research, we require Analysts to know the overall Industry Environment and necessarily that Competitive Forces are shaping a company's ability to Generate Profits/Performance.
Analysts look at the following for example:
· Market Size & Growth Rates
· Competitive Intensity
· Barriers to Entering the Market
· Supplier & Customer Bargaining Power
· Threat of Substitutes
As a result of all of the above Factors Analysts develop Practical Tools to Analyze Industries, so that we will have an Accurate View of how they develop over Time. Analysts will develop a Foresight of how to make Industry Decisions based on their history.
This Insight Allows Us to Make Decision about our Companies Based on Industry Structure and Dynamics as Opposed to individual company Performance. Even an exceptional company can have Difficulty Surviving in an Industry with a Poor Structure, while Even Average Companies Will Succeed in Favorable Industries.
This Perspective is Beneficial for Corporate Strategic Planning Decisions for example: new product Launch, New Market Entry Decision, Merger or Acquisition Evaluations, etc.
Developing a Long-Term Perspective
Equity Research is focused more on creating long-term value instead of short-term performance. While markets may respond to quarterly earnings, the analysts who work with equity research are trained to analyze to understand multi-year earnings potential and cash flow generation.
They must have both patience and strategic foresight. Analysts who read on Equity Research are taught to differentiate between:
- Temporary Set-Backs vs. Structural Problems
- Cyclical Declines vs. Secular Decline
- Short-term Noise vs. Long-term Trends
Businesses that think long-term are generally considered stronger business leaders. They make better capital allocation decisions are more purposeful in the way they invest into growth and remain resilient during unpredictable economic environments.
By continually projecting (a) business five to ten years out into the future, Equity Research instills this long-term way of thinking.
Understanding a Financial Statements as a Business Story
For equity research analysts, financial statements are not just accounts; they tell a story about how a business has performed. Analysts learn how to read the income statement, balance sheet, and cash flow statement as a series of linked stories.
Analysts ask questions such as:
- Why have margins shrunk or grown?
- What has changed working capital and how has it changed?
- How does the firm's cash flow behave and how likely is it to keep up?
Is growth coming from the company's own cash flow, or is it coming from borrowing money?
This type of investigation teaches an important lesson about business: the numbers in a company's financial statements reflect its decisions. Employment levels, pricing strategy, capital spending, and inventory management will all show in a company's financial statements.
As such, equity research analysts can use numerical relationships to help determine how management was able to make its decisions. This skill is important for many people who are either managing their own businesses or advising others about their businesses.
Capital Allocations and Value Creations
A key point in the business mindset has to do with determining how management invests the company's capital. Within equity research, this is emphasized through:
- Reinvestment in the business.
- Mergers & Acquisitions.
- Dividend payments to shareholders.
- Share repurchase programs.
- Reducing debt levels.
Analysts are taught that being profitable only by growing a business is not necessarily successful; it is essential for a profitable company to have an adequate return on the capital it utilizes. Therefore, if a company is growing rapidly but does not achieve a return on its capital that exceeds its cost of capital, then that company is creating destructive value.
This way of thinking fundamentally alters the way in which businesses are evaluated. As a business analyst, it teaches you the importance of being disciplined in your investments and that it prioritizes your investments. This provides companies with a very important "leadership skill", which is the ability to prioritize.
Assessing Management Quality and Incentives
A significant component of business insights is comprehension of capital allocation. Equity analysts determine how a company's senior management can allocate its resources to create long-term shareholder value through re-investing into its existing or operating business, participating in M&A activity, issuing Dividends, repurchasing stock, reducing debt and repaying debt; education is based on a fundamental belief that it is not only the rate of a company's growth but also the level of Return on Capital (ROC) that creates value. Companies that cannot achieve a high enough ROC, based on their operational expenses or cost to the investors, will eventually erode shareholder value, regardless of their level of growth. Understanding this improves an analyst's ability to evaluate a company's business operations and facilitates the discipline in making sound investment decisions, as well as developing effective strategies as a leader by having a clear understanding of a company's priorities and resource allocation decisions.
Risk Assessment and Decision making under Uncertainty
All businesses have some element of risk associated with them, so equity research is essentially about evaluating a business using limited information and estimating risk.
To evaluate risk, analysts continuously evaluate:
- Competitive Threats
- Legal Regulations
- Technological Changes
- Economic Trends
- Business Errors
The analyst will shift from thinking in deterministic terms to a more probabilistic approach. Instead of asking, "What will happen?" the analyst will now ask, "What could happen? And what is the probability that it happens?"
When doing this, the way the analyst makes their decision will improve. By forcing the analyst to perform scenario analyses, add safeguards to protect against losses, and incorporate the concept of margin-of-safety, they develop a more conscientious business judgment.
Synthesizing Information and Forming Independent Views
Through processing large amounts of data and synthesizing them into an investment thesis, equity research prepares analysts to do four things:
- Filter signal from noise
- Determine what is important
- Form their own conclusions
- Support their opinions with reason and evidence
As business leaders are inundated with information daily, they need the skill of taking complex material and distilling it down into actionable insights. Through repeated practice of equity research, this skill becomes second nature.
Communication and Persuasion
No matter what type of businesses you run, every successful business must be able to communicate its ideas clearly to be successful. Equity research requires individuals to develop detailed reports, develop and deliver business case presentations, and respond to challenging investor inquiries, as well as being able to clearly present their ideas.
Individuals who develop effective communication skills through the process of developing reports and business cases will develop skills that directly translate to leadership, strategy, consulting and entrepreneurship positions, where it is vital to be able to influence key stakeholders.
Building an Owner’s Mindset
One of the greatest takeaways from learning about equity research will be understanding how to view a business or company as if you personally own it. That is, equity analysts value businesses based on what they think those businesses would be worth if they bought the entire business, not based on what the stock price is today.
By utilizing this mindset of ownership, one would consider:
- -Long-term value creation
- -Sustainable competitive advantages
- -Prudent risk-taking
- -Accountability for Results
The thought process of "thinking like an owner" encourages people to take an entirely different approach to problem-solving than what they would take if they were simply looking at stock performance or try to maximize short term profit through stock trading.
Transferability Beyond Transfer
The analytical skills developed through an Equity Research Analyst's previous experience is very broadly applicable to many roles. Some examples of common roles that use the analytical skills developed within equity research include:
- Corporate Strategy
- Private Equity/Venture Capital
- Consulting
- Entrepreneurship
- Senior Management
Equity Research teaches people not only what to think but also how to think about companies. The Equity Research process teaches an individual to think within a structure, build a structured approach to analytical thinking, and develop the strategic mindset needed for virtually any decision-making role.
Conclusion
Conducting equity research provides much more than just insight into finance; it provides insights into how to think about running and managing a business. Analyzing the structure, industry, management, and financial statements of companies helps the researcher learn how to evaluate each company's business operation.
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