A Healthier Income Statement With A Few HR Tweaks

As can be seen with the demise of the mighty Enron, effective HR management is an integral part of any business. It’s about paying attention to detail and that means counting dollars and cents where it matters. For accountants, glaring mistakes are often noted on their client’s financials and nowhere is HR mismanagement more evident than on the income statement. Manual HR processes tend to leave too much room for interpretation, which could leave the employer open to risk. With the right systems in place, not only can employers reduce their risk but also improve their bottom line.

Choose The Right Talent The First Time

The statistics are not in favor of an employer where a bad hire is concerned. The U.S. Department of Labor estimates that a bad hire costs the company at least 30% of that employee’s first-year earnings. Onboarding new staff members cost businesses thousands of dollars and that figure spent on the wrong person is a tough figure to reconcile when the hire is bad. A good hire, on the other hand, will have a direct accounting effect which the figures on the income statement will reveal. 

Invest In Staff Growth

Richard Branson says “Train people well enough so they can leave, treat them well enough so they don’t want to”. A well-spent investment on staff will ensure that the bar is raised in the company which means a direct effect on the sales. An improved sales turnover contributes to a healthier income statement. An investment in staff is a direct investment in the workforce and very rarely does this investment have a nil return. The effect is not only felt on the production floor but can also translate to employee interactions with customers, which have a direct effect on sales. It can also lead to an in-house accountant or bookkeeper to keep track of those numbers while the business focuses on what it does best. 

Opt For Effective Workforce Management Tools

One of the biggest loopholes to affect an employer’s bottom line is ineffective workforce management. This is because there is no way to carefully monitor the comings and goings of staff, and leave management is not properly documented or transparent. Staff can be empowered through workforce management tools as they are able to manage themselves more effectively, placing less pressure on supervisors and managers. Developers Advanced Systems Inc suggest integration of different aspects of workforce management can be key to streamlining and effective, efficient business practices. It provides management will have a bird’s eye view of the workforce at any given time.

Is The HR Department Profitable?

Profit is the main topic of conversation when business owners sit down with their accountants. It’s not often that business owners look at the HR department purely from a profitability perspective, however, this is a division that can add directly to the bottom line. According to research, at least 50% of a company’s profit relies on the internal happenings of the business. There are a number of ways the HR department can make or break a business, and one of those is legal considerations. The right contracts and preventative measures ensure that the business focuses on other areas that help build profit.

Human capital is one of the biggest assets in any business, and time and money spent developing this side of the business often reap great rewards. The HR department is at the heart of every business and has a direct impact on the income statement, a very important consideration for any business owner.

 

How a Professional Accountant Can Help Your Business Grow

When we launch a startup or open a small business, it can feel like we have suddenly become a ‘jack of all trades’. From manufacturing our product of offering our services, right through to answering the phone, performing administrative duties, and even taking care of basic accountancy, no task is too small or too time-consuming. As we begin to achieve the success we have worked so hard for, one of the wisest steps we can take, is that of hiring an accountant. Indeed, those in the know argue that we shouldn’t even consider starting a business until we have received professional advice. An accountant can suggest the most appropriate business entity for our situation, help us avoid common pitfalls, and advised us on financing and how to mitigate risks.

Important Advise on Financing

When your business reaches an intermediate stage, you often have to consider additional forms of financing to enable you to expand your products, services, or premises. Unless you deal in financial services, you can undoubtedly benefit from an accountant’s advice on which type of financing to go for. A chartered accountant will be aware of SBA loans (developed to support business growth) and be able to present various options (including standard business loans, short-term loans, etc).

You should be especially vigilant about long-term loans, ensuring you pay the least amount of interest possible, so you have enough liquid funds to invest in new

Reducing Your Tax Bill

Tax laws are continually changing, and chartered accountants are always the first to find out about amendments that could affect your business positively. Incentives, tax breaks, and new penalizations can significantly affect your profits or losses. Forms can also be time-consuming to fill in, so leave the difficult work in hands of an accountant and rest assured that your business is totally compliant with current tax legislation.

Advise on Growth

Accountants are experts at analysis; by studying your books, they can analyze cash flow patterns, make important suggestions regarding how to cut costs by varying inventory, suggest interesting price changes, and highlight ways your company can move in new directions.

Helping You with Audits

So long as your financial matters are in the hands of a qualified and dedicated accountant, you needn’t worry about having to prepare an audit if required. Your accountant will be able to offer you support and explain communications sent by the Tax Department. An audit is no reason to panic if your finances have been in order from the start.

We are all experts in our own respective fields, which is why finances should be left to a professional accountant. Issues such as our business entity, financing, and tax matters, can be difficult and time-consuming to comprehend. By relying on an accountant, we can ensure that everything is order, risks are kept to a minimum, and we invest in what we truly know: making our clients happy with products or services we believe in so much, that we have based our professional life on them.

Bad Credit & Your Business

Your credit score can affect you in a number of ways and this can extend beyond your personal credit abilities. Many small businesses feature an interplay of personal finance and business finance. Did you know that a study by the NSBA found that 27% of US businesses were not able to secure their required funding? Furthermore, 25% of them said it prevented them from expanding.

With the link between personal financial health and business financing needs, a bad credit score can influence your business’ ability to expand and succeed. To avoid these side effects, there are many tools and information resources available to business owners. If you are one of the many entrepreneurs that are looking for help in overcoming these effects, Crediful can help refinancing with bad credit.

Borrowing

One of the most important ways a poor credit score can affect your business is by restricting your borrowing ability. When seeking funds, banks and lenders will look at your business credit score and your personal credit score. According to the Small Business Administration, a total of 65 percent of small businesses utilize a credit card or business loan. A low score signals to the lender that there may be an inability to repay the loan in the future or an inability to effectively manage your finances. To your creditor, this can be seen as too risky.

Although some small businesses do manage to secure financing with a low credit score, a higher premium is often charged to compensate for the higher risk. Therefore, financing may not be as flexible as many other small business loans. Higher interest rates and finance charges then filter down to your business’ bottom line, impacting the profit margins.

Trade & Creditors

A good credit score is not just vital in securing business financing but may also affect your interactions with creditors. Many vendors including property real estate companies consider your credit score when determining whether to do business with you. This is especially applicable to trade creditors as their credit terms are often adapted and your business may be faced with a very short repayment deadlines.

Start-Up Capital

Poor credit can affect your ability to secure any financing at all and therefore, chances of your business even getting off the starting blocks may be very slim.. If this happens, you may be forced to consider alternative forms of financing or the use of collateral such as your home.

However, there are ways and many financial tools to help you turn your credit score around. Although being hampered by your credit score can feel defeating, there are many small business grants and lenders specifically for people in your situation.

When Your Hobby Becomes a Small Business: What You Need to Know About Accounting

Whether you’ve been knitting, painting, creating pottery or making jewelry, you may find that your hobby has become more than that, and you are starting to make money. The rise of websites such as Etsy, Artfire and other craft and hobby blogs, have made it easy to sell your products and wares online. Every small business needs to exceed when it comes to accounting and keep records for their taxes. Having a good control of your finances will mean that you are able to grow and expand your small business as you want to.

When does your hobby become a business? 

To determine whether your hobby is a business, the IRS will ask a series of questions. The two most basic questions are:

1. Are you putting in the effort and time with the intention of making a profit?
2. Are you relying on the income from the hobby/business?

It is important to establish this, as running a business will mean that you can offset any related expenses against your profit when you are declaring your small business profits. These deductions can include materials that you have used as well as a deduction for use of your home space for your business. If you are turning your hobby into a startup, you need to keep a firm track on any deductions you want to make. This will help you with your taxes.

Keep a separate bank account

In order to keep your accounts and taxes simple and transparent, it is a good idea to open a new bank account for your small business. This will help you see when you’re spending on your own personal expenses and help to ensure that you aren’t making any tax deductions that aren’t related to your business. Industry professionals GR-US.com  suggests keeping a separate bank account to help maintain a positive cash flow. If the IRS wants to request an audit or look further into your accounts, this will make life easier. It also looks more professional, especially if you are requesting direct bank payments from customers.

Use a software accounting package

Investing in a good software accounting package (like Clever Accounting) for your business is a must. This will help you to keep track of your cash flow and expenses. It will also help you to accurately invoice customers and the payments they have made. Using a good accounting package can help transform your hobby business into a thriving enterprise, giving you the time to focus on your products and services.

What is the Border Adjustment Tax? Potential Benefits and Risks

More likely than not, you have recently found yourself barraged with headlines regarding the border adjustment tax (BAT), a portion of the Republican House Tax Reform Blueprint intended to overhaul the current U.S. corporate tax code. The proposal has emerged in response to common criticism that the current corporate tax rate of 35% and offshore tax deferrals create incentives for multinational companies to outsource jobs, make offshore investments, and take on unnecessary domestic debt.

While there would surely be winners, losers, and an estimated $1 trillion raised in revenue with the implementation of the proposed tax code, it is difficult to determine its exact implications without the actual legislative language, which has yet to be provided. With the nation coming off the heels of a failed healthcare reform attempt, the GOP will be making tax reform its top priority. Regardless of which side you sit on, you will want to understand the potential implications.

The BAT taxes imports, but not exports.

According to the nonpartisan Tax Foundation, a border-adjustment tax conforms to the “destination-based” principle whereby the tax is levied based on where the good is consumed (destination), instead of where it was produced (origin). Put simply, a BAT taxes imports but not exports, creating incentives for companies to import less and export more—a significant shift for the U.S. economy, which is heavily dependent on global supply chains.

The House proposal applies a border adjustment to the U.S. corporate income tax. Per the plan, U.S. corporations would no longer be able to deduct the cost of purchases from abroad (imports) and would no longer be subject to taxes on revenue attributable to international sales (exports).

Despite common misconceptions, the border adjustment tax is neither a tariff nor a value-added tax. A tariff is a tax imposed only upon imports, and can be applied selectively to certain products, companies, or countries. In contrast, the border-adjustment tax in consideration would affect all imports and exports, and all countries.

In addition, the border adjustment tax is not a value-added tax (VAT), a taxation system widely adopted across the globe (employed by 140 of the world’s 193 countries). Corporations under the VAT are not permitted payroll deductions from taxable income, while the proposed plan does permit payroll deductions. This seemingly insignificant detail could have crucial compliance implications with existing World Trade Organization (WTO) agreements, which will be discussed further into the article.

The border adjustment is a component of the broader house proposal.

The major components of the House proposal include:

  1. A border adjustment.
  2. A decrease in the corporate tax rate from 35% to 20%.
  3. Interest expenses no longer being deductible.
  4. Capital investments that may be fully written off or expensed immediately, as opposed to over time (as is currently done).

So it is important to understand that the border adjustment is only an element of the broader House proposal, a point some commentaries tend to confuse.

With the changes outlined above, the new tax system would essentially become a “destination-based cash flow tax” (DBCFT). Here is a breakdown:

Let us apply the BAT to three hypothetical situations.

One other consideration in this scenario is the potential appreciation in the value of the dollar. According to economic theory, by exempting U.S. exports from taxes, the border adjustment would initially create higher demand for U.S. goods and U.S. dollars. Simultaneously, by taxing imported goods, there would be lower demand for foreign goods and currencies.

Thus, the expected combined result would be a rise in the value of the dollar. Economists are split on whether or not it would occur. However, if the currency rates work as intended, the value of the dollar would appreciate and the cost of purchasing imported goods would decrease.

The BAT aims to raise tax revenue, eliminate incentives to offshore profits, and simplify the current tax code.

Raise tax revenue: In the context of the broader proposal, a border adjustment would generate an estimated $1.1 trillion over the next ten years, which could be used to offset the loss in revenue resulting from the lower corporate tax rate.

Eliminate incentives to move profits offshore: It would eliminate profit-shifting strategies currently utilized by multinational companies such as Apple and its Irish subsidiaries. Since import expenses cannot be deducted from taxable income, it cannot change its domestic tax liability. On the flip side, exports are excluded from taxable income, so tax liability is similarly unaffected. The proposal would eliminate incentives to place intellectual property abroad or load up domestic operations with debt.

Simplify the current tax code: This may seem counterintuitive given the seemingly complicated mechanics of border adjustment taxes. However, the main reason why it would simplify the tax code is because it is easier for corporations to determine where its sales occurred, rather than where the production occurred. According to the Tax Foundation:

“It will probably turn out to be much less complicated than the byzantine tax rules that currently govern businesses today. The border adjustment would eliminate the need for firms to comply with our complex rules governing controlled foreign corporations (CFCs), passive foreign income (Subpart F), transfer pricing, interest allocation, foreign tax credits, and accounting for deferred taxes. Under a border adjustment, all companies would need to account for is what items they purchase from abroad and what products they send abroad.”

However, the BAT comes with a slew of risks.

WTO violation: While the proposed plan is inspired by the consumption-based VAT, the possibility of it being income-based rather than consumption-based is at the root of much controversy. Consumption taxes do not allow for payroll, interest, or depreciation deductions, as they pertain not to taxable income but to consumption. The House proposal, crucially, includes a provision allowing payroll deductions from taxable income.

Consequently, according to KPMG, it is unclear whether the proposal would replace the current income tax with a consumption tax, or whether it would technically remain an income tax that closely mimics a consumption tax. This distinction has the potential to create inconsistencies with existing World Trade Organization commitments against protectionism. Compliance hinges on whether or not labor costs can be deducted from gross revenue to determine taxable income. If so, the reform would effectively be a corporate income tax with immediate 100% depreciation, disqualifying it as value-added, and would thus be considered a violation.

Increased Consumer Prices: Experts are divided as to whether the border adjustment tax would cause increased consumer prices. Some experts argue that businesses would almost certainly pass the cost increases to consumers, who would experience price hikes in imported goods (including everything from foreign cars and gas to avocados and clothing). David French, SVP of government relations at the National Retail Federation, recently commented, “I really hope everybody understands that what they’re really talking about is a 20% tax on the U.S. consumer.”

There is a fear that this cost burden will be particularly difficult for working class and middle class families to shoulder. For example, if the tax includes oil imports, rural Americans will likely be more affected than the more affluent residing in cities.

Others argue that though the 20% import tax might be passed onto customers in the short to medium term, it would concurrently cause an appreciation in the dollar value that would eventually neutralize the additional consumer cost. Harvard economist Martin Feldstein believes that, in accordance with economic theory, the U.S. dollar would appreciate to 125% of its current value—an amount that would more than counter the expected 20% increase in the price of imported consumer goods.

However, this assertion has faced apprehension as skeptics cast doubt around Washington’s ability to accurately predict future foreign currency exchange rates. Skeptics emphasize the sheer number of factors influencing such rates, including federal rate increases, commodity prices, and the overall strength of the U.S. economy.

Foreign retaliation: If the U.S. tries to implement an inconsistent tax regimen, countries could appeal to the WTO and initiate investigations seeking compensation for illegal subsidies received by U.S. exports—ultimately risking a trade war. Opponents point to a risk of retaliation from other countries in response to the change in U.S. policy, potentially drawing $385 billion in tariffs from our trading partners, according to the Peterson Institute for International Economics. The key trigger of this scenario would be if the proposed changes violate existing WTO commitments, something which is still unclear given that the specifics of the proposal remain to be finalized.

Given the significant effects of the BAT on certain countries (Chart 2), the risk of retaliatory policies is not insignificant should the BAT violate WTO rules. Perhaps unsurprisingly, Deutsche Bank AG economists Robin Winkler and George Saravelos found that Mexico, Canada, and some Asian countries (primarily Thailand and Malaysia) have much to lose should the proposal be implemented, as measured by net trade impact as a percentage of GDP. The fact that Mexico and Canada—two of the U.S.’s largest trading partners—already have the ability to utilize retaliatory tariffs on imports from the U.S. based upon a 2015 settlement by the WTO, makes this threat all the more concerning.

U.S. sectors would be affected at varying levels: Companies are often exposed more heavily on one side of the import/export equation. (e.g., Technology companies that export in high volumes would benefit from the policy, while retailers that import and sell in high volumes would be at a disadvantage). This imbalance would likely be criticized as prejudicial and create sharp divisions among businesses, as they already are.

Companies who are reliant upon imports might not be able to adjust to such an abrupt change: Opponents of the policy have voiced concerns that domestic businesses reliant on imported goods would be harmed by such an abrupt and drastic change. They worry that these companies have long been making strategic decisions and investments assuming a certain set of rules and may be unable to adjust to the shift. Budget retailers heavily reliant upon imported goods are particularly vulnerable to such a change.

American investors would be disadvantaged: If the plan works as intended, then the appreciation of the dollar would hurt Americans who own foreign assets, such as a mutual fund including assets in euros. It is estimated that the loss would be more than $2 trillion.

Though similar to the BAT, the VAT is less controversial.

Border adjustments have historically been popularized and utilized in the context of value-added taxes, a popular taxation system employed across the globe. However, it is a relatively novel concept when applied in the context of corporate income taxation—as is the case with the current U.S. tax reform proposal.

It is important to note that the proposed plan and the VAT are in fact distinct and possess key differences. For one, while the proposed plan is inspired by the consumption-based VAT, consumption taxes typically do not allow for payroll, interest, or depreciation deductions, as they are concerned not with taxable income but with consumption. However, the proposed plan, as mentioned previously, indeed allows for payroll deductions.

In addition, the VAT effectively acts as a sales tax with no competitive impact. According to the EU Taxation and Customs Union, businesses act as VAT collectors while the end consumer actually carries the entire burden of the VAT. Consequently, consumers under the VAT system are comparable to U.S. consumers paying sales taxes on products. In addition, as economist Paul Krugman reinforces throughout his widely-cited paper, the VAT does not create subsidies or trade barriers.

Consider how imports (from the U.S.) and exports (to the U.S.) would be treated by a UK company under the VAT:

Exports: Under the U.S. sales tax system, American companies do not pay sales taxes on purchases made throughout production. However, the UK company pays VAT along the production process but cannot collect it from buyers of goods sold abroad. This is where a rebate is introduced and plays a crucial role: the system allows the UK company to reclaim the VAT already paid out.

Imports: If the UK company imports American goods and sells them, the consumer has to pay the VAT all the same. The UK company then turns this VAT over to the government. Therefore, the U.S. goods are treated in the same manner as the ones produced in the UK. Ultimately, the VAT is neutral.

Let us turn to past instances of high import taxes and foreign retaliation.

Despite a lack of historical examples of border adjustments applied to income taxes, we can learn from past instances of high import taxes and foreign retaliation. As Jeremy Siegel of the University of Pennsylvania warns, “if protectionism does break out globally, it would be disastrous […] if there is a trade war, the market would react extremely negatively […] we’d be down 10% to 15%.”

In the early 2000s, in the biggest case in which the WTO has granted retaliation, the U.S. was found to be unfairly subsidizing exports using certain tax exemptions. As a result of that, in 2003, the WTO permitted the European Union’s (EU) adoption of $4.04 billion in retaliatory tariffs against the U.S. The EU then instituted tariffs on U.S.-based products including everything from leather to nuclear reactors. In response, the U.S. eventually repealed the tax exemption and the tariffs were removed.

In another instance in 2009, a retaliatory tariff imposed by Mexico onto the U.S. regarding cross-border trucking permits reduced the sales of certain U.S. farm products in Mexico by 22% over the course of 18 months, or around $984 million in lost exports. While this number may not seem significant relative to the cumulative annual export amount, it is indicative of other countries’ willingness to take action against perceived injustices, and the significant impact it can have on targeted industries.

On the other hand, it is also worth noting that currency markets can respond quickly to U.S. policy changes, including the frequent fluctuations in Mexican peso values during the 2016 presidential election. In addition, over 140 countries have a border-adjusted tax as part of their VAT regimes, and there is a vast body of literature related to this which shows showing why currencies would adjust.

However, the Tax Foundation warns that “even if currencies adjust quickly, some factors may slow the speed at which import prices adjust to those changes, including the fact that many goods are priced in dollars internationally.”

Potential alternatives, though imperfect, may yield fewer negative consequences.

A potential alternative to the border adjustment tax would be a smaller straight tax cut. A lower corporate tax rate coupled with looser regulation could add upwards of 10% to corporate earnings, which could cause a ripple of growth across the larger economy.

Another option would be a partial or reduced border adjustment tax, which would maintain the overarching structure of the DBCFT but allow for partial deductions for imports and partial tax exports. Tom Barrack, adviser to President Trump, suggested a border adjustment of 10% instead of 20%. However, this option would add additional complexity to the pure border adjustment model, and might yield negative implications for revenue neutrality.

Alternatively, the U.S. could end the ability for companies to defer taxes on their foreign profits, which would remove the incentive for multinational companies to move their profits into offshore tax havens and raise almost $1 trillion in revenue. This could be paired with an effort to close existing tax loopholes in the tax code, such as requiring companies to pool their foreign tax credits and removing distortive tax expenditures such as accelerated depreciation or domestic manufacturing credit.

Going Forward

It is difficult to predict what will happen regarding the House proposal, especially given the President’s unclear stance on the matter. While some organizations are already positioning themselves in anticipation of its implementation, such as hedge funds increasing their exposure to futures and options linked to WTI (domestic crude oil), others, such as large retailers, are publicly voicing their fierce opposition.

Still, with the combination of the proposed tax reform, Brexit, and the European elections, we may see significant currency exchange volatility in the near future as the system absorbs and adjusts to these changes.

This article is originally posted in Toptal.

Getting the Most from Equity Research – Lessons from a Former Research Analyst

My Wall Street journey started with Bloomberg in 2009. Since then I’ve held positions in equity research at a sell-side shop, as a senior analyst at a hedge fund, and eventually, as the director of research for a startup building research automation tools. During that time, I have produced hundreds of reports, models and recommendations on publicly traded equities.

As a result of this, I’ve been able to develop a profound understanding of the value, as well as the pitfalls of equity research. This article is intended to share with you some of the most important lessons I have learned, and guide you on how to use research reports more effectively.


Whilst the equity research industry worldwide has endured substantial declines since 2007, there are still roughly 10,000 analysts employed by investment banks, brokerages, and boutique research firms. And even more analysts offer their services independently or on a freelance basis, and there are still more voices in the crowd contributing to blogs or sites like SeekingAlpha.

The reason for the above is clear: equity research provides a very useful function in our current financial markets. Research analysts share their insights and industry knowledge with investors who may not have them, or may not have the time to develop them. Relationships with equity research teams can also provide valuable perks, such as corporate access, to institutional investors.

Nevertheless, despite its obvious importance, the profession has come under fire in recent years.

Analysts’ margin of error has been studied, and some clear trends have been identified. Some onlookers bemoan the sell-side’s role in stimulating equity market cyclicality.

In some cases, outright conflicts of interest muddle the reliability of research, which has prompted regulation in major financial markets. These circumstances have generated distrust, with many hoping for an overhaul of the business model.

With the above in mind, I’ve divided this article into two sections. The first section outlines what I believe the main value of equity research is for both sophisticated and retail investors. The second looks at the pitfalls of this profession and its causes, and how you should be evaluating research in order to avoid these issues.

Why Equity Research is Valuable

Sophisticated Professional Investors

As sophisticated or experienced investors, you likely have your own set of highly developed valuation techniques and qualitative criteria for investments. You will almost certainly do your own due diligence before investing, so outside parties’ recommendations may have limited relevance.

Even with your wealth of experience, here are some things to consider.

To maximize the use of your time, buy-side professionals should focus on the research aspects that complement their internal capacities. Delegation is vital for every successful business, and asset management is no different. External parties’ research can help you:

Enhanced Corporate Access

Regulations prevent corporate management teams from selectively providing material information to investors, which creates limitations for large fund managers, who often need specific information when evaluating a stock.

To circumvent this, fund managers often have the opportunity to meet corporate management teams at events, hosted by sell-side firms that have relationships with executives of their research subjects.

Buy-side clients and corporate management teams often attend conferences that include one-on-one meetings and breakout sessions with management, giving institutional investors a chance to ask specific questions.

Language around corporate strategies, such as expansion plans, turnarounds, or restructuring, can be vague in conference calls and filings, so one-on-one meetings provide an opportunity to drill down on these plans to confirm feasibility.

Tactful management teams can confirm the legitimacy and plausibility of strategic plans without violating regulations, and it should quickly become obvious if that plan is ill-conceived.

Institutional clients of sell-side firms also have the opportunity to communicate the most relevant topics that they want to see addressed by company management in quarterly earnings conference calls and reports.

Deeper Insight

The sell-side analyst’s public role and relationship with corporate management also allows him to strategically probe for deeper insights. Generally, good equity research demonstrates the analyst’s emphasis on teasing out information that is most relevant to institutional clients. This often requires artful posing of incisive questions, which allows management teams to reach an optimal balance of financial outlook disclosure.

Buy-side analysts and investors have a massive volume of sell-side research to comb through, especially during earnings season, so succinct, analytical pieces are always more valuable than reports that simply relay information presented in press releases and financial filings. If these revelations echo the interest or concerns of investors, the value is immediately apparent.

Outsourcing Tedious or Low-ROI Aspects of Research

Smaller buy-side shops may lack the resources to monitor entire sectors for important trends. These asset managers can effectively widen their net by consuming research reports. Sell-side analysts tend to specialize in a specific industry, so they closely track the performance of competitors and external factors that might have sector-wide influence. This provides some context and nuance that might otherwise go unnoticed when concentrating on a smaller handful of positions and candidates.

Research reports can also be useful ways for shareholders to spot subtle red flags that might not be apparent without carefully reading through lengthy financial filings in their entirety. Red flags might include changes to reporting, governance issues, off-balance sheet items, and so forth.

Buy-side investors will of course dig into these issues on their own, but it’s useful to have multiple eyes (and perspectives) on portfolio constituents that may number in the hundreds. Likewise, building a historical financial model can be time consuming without providing the best ROI for shops with limited resources. Sell-side analysts build competent enough models, and investors can maximize their added value by focusing entirely on superior forecasting or a more capable analysis of the prepared financials.

Idea Generation

Identifying investment opportunities falls under the umbrella of tedious activities since effectively screening an entire market/sector can be overwhelming for a smaller team at some buy-side shops. As such, idea generation has become an important element of some sell-side firms’ offerings. This is especially pronounced regarding small and medium cap stocks, which may be unknown or unfamiliar, to institutional investors.

It’s simply impractical for most buy-side teams to cover the entire investable universe.

Research teams fill a niche by identifying promising smaller stocks or analyzing unheralded newcomers to the market.They can then bring this to the attention of institutional investors for further scrutiny.

Creating Context

Reports might be most useful for sophisticated investors as an opportunity to develop a meta perspective. Stock prices are heavily influenced by short-term factors, so investors can learn about price movements by monitoring the research landscape as a whole.

Consuming research also allows investors to take the temperature of the industry, so to speak, and compare current circumstances to historical events. History has a way of repeating itself in the market, which is driven in part by the industry’s tendency to shake during crashes, and pull in new professionals during bull runs.

Having a detached perspective can help shed light on cyclical trends, making it easier to identify ominous signals that might be lost on the less acquainted eye. In turn, this drives idea generation for new investing opportunities.

With that being said, investors should not consume research that only confirms their own bias, a powerful force that has clearly contributed to historical booms and busts in the market.

Retail Investors

The value of equity research is much more straightforward for retail investors, who are usually less technically proficient than their institutional counterparts.

Retail investors vary substantially in sophistication, but they mostly lack the resources available to institutional investors. Research can supplement deficiencies on some basic levels, helping investors with modeling guidance, framing an investment narrative, identifying relevant issues, or providing buy/sell recommendations.

These are great starting points for retail investors seeking value out of research. Individuals probably can’t consume the sheer volume of reports that asset managers can, so they should lean on the expertise of trustworthy professionals.

What are the risks associated with equity research?

Despite the above, there are clear risks to over-relying on equity reports to make trading decisions. To properly assess the dangers of equity research, one must consider the incentives and motivations of research producers.

Regulations, professional integrity, and scrutiny from clients and peers all play significant roles in keeping research honest, but other factors are also at play. Research consumers should be mindful of the producer’s business model. I highlight the five key issues below.

Equity research can be exaggerated due to the need to drive trading volumes

Reports that are produced by banks and brokers are usually created for the purpose of driving revenues. Sell-side equity research is usually an add-on business to investment banks that earn significant fees as brokers and/or market makers in traded securities and commodities.

As a result of this, research tends to focus on highlighting opportunities for buying and selling stocks. If research reports only included forecasts of “steady” performance, this would result in less trading activity. The incentive for research analysts is therefore to come out with predictions of a change in performance (whether up or down).

This isn’t to say the content of the research is compromised, but that opinions on directional changes in performance may be exaggerated.

Numerous academic studies and industry white papers are dedicated to estimating the magnitude of analyst error. The findings have varied over time, between studies and among different market samples. But all consistently find that analyst estimates are not particularly accurate.

Andrew Stotz indicates an average EPS (earnings per share) estimate error of 25 percent from 2003 to 2015, with an annual minimum under 10 percent and annual maximum over 50 percent.

Research analysts may avoid criticizing companies they cover due to the need to maintain a positive working relationship

Another important point to consider is that analysts generally benefit from having a positive working relationship with the executive management and investor-relations teams of their research subjects.

Analysts rely on corporate management teams to provide more specific and in-depth information on company performance that is not otherwise publicly provided.

Brokers also provide value to investors by providing seminars and one-on-one meetings that are attended by those executive teams, so a strong roster of presenters at conferences can be dependent on the relationships built by the research teams.

I’ve witnessed the negative impact of a souring relationship:

One of the tech analysts at a company I worked for was covering a small-cap stock and built up a good relationship with both the corporate management team and the investor relations person who worked with them. Being a small company, this visibility was valuable to the research subject.

Poor results one quarter were downplayed by management as a temporary speed bump, but the analyst had concerns that these were longer-term problems.

The executive team was upset when the subsequent report negatively portrayed the recent events, and soon thereafter withdrew from an upcoming conference our research firm hosted. The analyst’s bonus compensation suffered as a result as well.

Obviously, this all has very serious implications.

Sell-side analysts tend to produce reports that portray their subjects favorably, and they are more likely to set attainable expectations. It also means that analysts may hesitate to downgrade a company’s stock. This is especially true when poor executive management would be the primary culprit causing a downgrade. All of this may help explain why EPS estimates are disproportionately bullish (see chart 2).

Research analysts may avoid making contrarian calls due to the need to maintain good reviews and a trusted reputation.

Equity research reports are influenced by the means by which analyst quality is measured. Analysts compete with peers at rival banks.

Taking a contrarian stand that results in bad recommendations could genuinely harm an analyst’s compensation and career prospects. These mechanisms create a herd-like mentality.

This can be extremely detrimental if it goes unnoticed or unaddressed by research consumers. These are precisely the sorts of circumstances that fuel bubbles. It’s hard to look especially foolish if everyone else looks foolish too.

Independent equity research may be sensationalized due to the need to stand out.

Research produced by independent firms, which substantially derive all revenues from the sale of research and do not maintain a brokerage business, is not meant to motivate trading.

This eliminates some of the conflicts of interest inherent in the sell-side banks, putting extra emphasis on accuracy. However, independent and boutique analysts are tasked with creating income by selling something that’s been largely commoditized, and they compete with banks that have vast resources.

To survive, they have to offer something specialized or contrarian. Their philosophy must radically depart from the herd. They have to claim special industry knowledge through independent channels, or they must cover stocks that are largely uncovered by the larger powers in the research space.

This creates the incentive for sensationalized research that can attract attention amongst the sea of competing reports.

Putting it all together

As we have seen, there are important facets of the equity research profession that often lead to skewed incentive mechanisms, and may ultimately compromise the quality of research being done.

To be fair, the practice of making complex and precise forecasts is necessarily flawed by the requirement to make assertions about future conditions, which by definition are unknowns.

Nevertheless, whilst this might be acceptable if the errors appeared random and with a predictable margin of error, this is not the case.

According to Factset research, consensus 12-month forward EPS estimates for S&P constituents were about 10 percent higher than the actual figures for the years 1997-2011. These numbers are skewed by large misses, and the median error is only 5.5 percent, but several important conclusions can be drawn:

How can you avoid equity research pitfalls?

There are several ways that consumers of research reports can judge the validity and quality of such reports,in light of what’s been discussed above.

Analyst Credentials

Analyst credentials are an obvious method for vetting quality. CFA designations don’t necessarily guarantee quality, but it indicates a baseline level of competency.

Research produced by reputable banks ensures that it was created and reviewed by a team of professionals with impressive resumes and highly competitive skills. Likewise, veterans of big banks who leave to start an independent shop have been implicitly endorsed by the HR departments of their former employers.

Producers can also be distinguished by specialized backgrounds, for example former doctors turned healthcare analysts or engineers weighing in on industrial/energy stocks. If the analyst has been recognized in financial media, it usually indicates extremely high quality.

Analyst Track Record

Investors can also look at historical analyst recommendations and forecasts to determine their credibility.

Institutional Investor provides a service that tracks analyst performance, and there are similar resources available, especially for investors with deep pockets.

Fintech startups, such as Estimize, actually focus on attracting and monitoring analyst recommendations to identify the most talented forecasters.

However, while third-parties and financial media offer helpful ranking systems based on earnings forecasts or performance of analyst recommendations, these tend to put a lot of emphasis on short-term accuracy. This might therefore be less useful for consumers with a long-term approach or emphasis on navigating black swans.

Investors should consider these factors and look for red flags that an analyst is hesitant to turn bearish. These could include shifting base assumptions to maintain growth forecasts and target prices, suddenly shifting emphasis away from the short-term to the long-term outlook, or perhaps an apparent disconnect between the material presented in the article and the analyst’s conclusions.

Understanding the Context

Investors should also consider context.

Some stocks simply don’t lend themselves to reliable research. They might have volatile financial results, an unproven business model, untrustworthy management, or limited operating history, all of which can lead to wide margins of error for earnings growth and intrinsic value.

The business cycle’s phase is also extremely important. Research shows that forecasts are less reliable in downturns, but investors are also more likely to rely most heavily on research during these times. Failure to recognize these issues can severely limit one’s ability to glean full value from research.

Research consumers should also make sure they know their own investment goals and be mindful about how these differ from those implied by research reports. A temporal mismatch or disconnect in risk aversion could completely alter the applicability of reports.

Consume a lot of research, and hold analysts accountable

For those fund managers wishing for a more reliable research product, the most effective move is to vote with your wallets, and buy reports from the most accurate and conflict-free sources.

It might be expensive to source research from multiple sources, but there’s value in diversifying the viewpoints to which you are exposed.

It’s unlikely that you will move on from low-quality research if that’s all you are reading.

Additionally, consuming a large volume of research from different sources helps forge a meta perspective, allowing investors to identify and overcome worrisome trends in research.

Equity Research Continues to be Useful, but Should be Consumed Thoughtfully

The equity research industry has undergone profound changes in recent years, due to regulatory changes, the emergence of independent research shops, as well as more automated methods of analyzing public company performance.

At the same time, smart investors are looking at broader sets of investments and taking a more active approach to research. This is facilitated by the increasing quantity of publicly available information on listed companies.

Nevertheless, good research continues to be extremely valuable.

It lets you manage a wider pipeline of investment opportunities and be more efficient.

An informed and thoughtful approach can enhance the value of research reports for investors, so asset managers can better serve clients (and their own bottom lines) by considering the content above.

Research consumers need to be wary of predictable errors, analyst incentives, conflicts of interest, and the prevalence of herd-like mentality.

If you can adjust your interpretation of research along these lines, then you can focus on the most valuable aspects of research, namely idea generation, corporate access, and delegation of time-consuming activities.

This article is originally posted in Toptal.

Photo credit: rednuht via Visualhunt.com / CC BY

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