Monday, July 27, 2009

Financial Sector participants – II

Bunch II – Guys who work with the markets

This category comprises of two sub-sections, buy-side and sell-side. The buy-side is the one that buys/sells securities. These groups manage funds, invest in equities, debt etc and try to generate returns. Sell-side firms are the ones that work for a commission. Whenever buy-side firms trade anything, they do through a broking firm, paying anywhere between 10-45 bps for this transaction. This commission is the key revenue line for sell-side firms. In other words, buy-side firms generate on fund-based income, sell-side firms generate fee-based income.

Sell-side firms have 3 kinds of participants – analysts, sales guys and traders. Analysts are the ones that sweat over balance sheet, P&Ls and the like, come up with recommendations for stocks and supposedly uncover value in equities. Sales guys propagate these ideas. They call up assorted buy-side firms and ask them to buy stocks which they (analysts and sales) think are undervalued and sell those which they think are overvalued. Traders are the guys who actually put orders through. They understand the mechanisms of the market and can get a sense of which direction the market is headed merely by watching the order book.

Analysts agonise over small details and generally pontificate about specific industries. They are the most pseudo-intellectual of the lot. They generally do not have the courage to put in any trades on their own but take great pride in sharing anecdotes about how they helped a client make lots of money. Particularly bitter analysts have a habit of recalling stories where a client lost money after having not listened to the sage advice from the analyst himself.

Sales guys have the individuality of a log of wood, a particularly uninteresting one at that. They peddle analysts’ views with any market flavour they can pick up. Sales guys spend hours on the phone recalling funny anecdotes from stories they heard while they were spending hours on the phone talking to other clients. Sales guys swear by the flavour of the season and pride themselves on knowing the pulse of the market.

Traders live for/in the moment. If they see a big buy order they conclude markets are indefinitely going up. If they see no activity in a day, they are generally depressed. These guys rarely care about anything beyond the immediate future.

On the buy-side, there are analysts and fund managers. Analysts are generally flunkeys who interact with fellow analysts in sell-side firms, provide internal research to fund managers, and generally do anything that helps them in their eternal quest to impress fund managers. Fund managers are the guys who manage portfolios, the ones who take the decision to buy/sell/not buy any stock. They are paid on the basis of their funds’ performance.

Now, where is the catch? If this is such a well-structured industry, where is the problem?. The problem stems from the fact that everything in the industry is relative or hidden. And every participant is allowed to hide behind some smokescreen. Cover-thy-ass is the underlying theme amongst all participants. Any research report will be littered with the following phrases – “in our view”, “we believe”, “increasing likelihood” etc. Now, equity pricing is an inexact science, so there is nothing wrong in getting things wrong. Except that, the pay packets of the participants hardly acknowledge the fact that this is an inexact science. Markets are random, investors bear the brunt of this, but employees are hardly affected. And, in my view that is wrong.

Imagine going into a hospital and the doctor says – “Look, in my view, you should take these tablets. There is a likelihood that these might help you” and follows up with – “ I must disclose to you that I might or might not have a stake in the pharma company that sells these tablets”. And for good measure, you find out that the doctor himself would never take these tablets. Not because he does not trust them. No siree. But because he wants to diversify his professional and personal risk. As in, if the tablet turns out to be bad, even if his professional reputation is ruined his personal health at least would remain. Remember, doctors generally earn about one-fifth of financial consultants globally.

Both diagnosis and stock-picking are inexact sciences. It is just lamentable that we set two standards for these two. The more crucial between doctors and analysts is set the more onerous set of restrictions, judged harder and has to get by with far lesser pay.

Now, coming to the part where the industry participants hedge their bets. Sell-side guys are in the business of generating commissions, not returns. So, they do enough to create chatter. According to the sell-side, the actual job of picking the right-stocks is with the buy-side. The motto is simple – Ours is not to buy or sell, ours is but to peddle (paraphrasing Alfred Tennyson). Even within this, the structure helps these guys out. The research analysts are slightly reticent; while the sales guy is at liberty to say whatever he wants, because in the end he is just providing market view (albeit with a bias). On the buy-side, the analysts do not take any calls, so it is impossible to blame them. The fund managers, who are the only ones who can be pinned down to something (because they have a clear P&L) have numerous ways of getting away with it. Fund managers are generally measured only relative to the market. So, their play is simple – allocate 85% of portfolio to the standard stocks (market), have 4 companies where you have inside information, park 10% of your portfolio here, and place 5% of funds base on your analysts’ recommendations and blame them if things go wrong. Everyone is happy this way.

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