High Impact Research: Short-Term Example

After writing about the role of an equity research analyst on Wall Street, I thought it would be appropriate to touch on High Impact Research. I’m sure volumes of books have been written on it and more will be forthcoming. High Impact Research is difficult to quantify so I will provide a short-term and a more long-term example of how to provide institutional investors a differentiated call.

The short-term call was a Motorola downgrade. I changed my price target on Motorola from $200 to $120 driving the stock downward along with the NASDAQ and the tech sector in May 2000. The call was driven by several pieces of innocuous information that created a “somewhat” clear picture that my positive thesis was incorrect so I cut my earnings estimate, contracted my P/E Ratio assumptions and downgraded the stock.

I use the term innocuous because each piece of information on it’s own “may” be insufficient to change my recommendation on a company that should be a beneficiary as industry growth was about to accelerate. There were several pieces of the puzzle my team and I learned after attending a series of analyst conferences and trade shows over a period of a couple of months that culminated with a visit to the company’s headquarters. The two most important pieces were a loss of a contract of insignificant size and a “very slight” change in management’s tone.

At the show room floor of a trade show, we had “unconfirmed” reports Motorola might have lost a contract to upgrade or expand British Telecom’s (BT) GSM network in a small European country. Normally, this would not really be read as very big news. Motorola had several billion dollars in sales of base stations and this was probably a rounding error. Moreover, companies win and lose business all the time. It was a waste of time to try and count each one, especially, one as tiny as this deal and Motorola was known as a handset manufacturer than an infrastructure supplier.

I did file it on the front of my memory banks because BT was a long-time “loyal” customer. Upgrades and expansion of existing systems was generally less expensive to do with your existing supplier. For BT to use someone else was going to be expensive, it was a path worthy of further exploration. At about the time we were exploring the ramifications of this piece of information, we had a pre-scheduled meeting at Motorola’s headquarters.

Ed Gamms, VP of Investor Relations, had arranged for me to visit with Motorola’s Chairman and CEO Chris Galvin. As I normally do, I also asked about a dozen of their largest shareholders to tag along. It was a win-win for everybody. Motorola got to sit down to hear from their largest shareholders, the investors got to sit down with company executives and I got to spend time with both.

The meeting started the same way every other meeting started, with slides but since everyone was very familiar with the story, we quickly switched it to a question and answer story. Chris confirmed in not so many words the BT story and indicated that it there still was a possibility they could get it back. My thoughts were “small contract loss has the Chairman’s attention.”

At every single investor meeting whether large or small, someone ALWAYS asks about the next quarter’s estimates and the full year forecast. Management will generally not tell you anything. It’s up to you to read between the murky lines. Sometimes you will be right and sometimes you will be wrong, but you have to place your bets on the table.

The question did come up near the end of the meeting. The answer from Chris was “we continue to be comfortable with our forecast…” If he had stopped his sentence right there, I would’ve left the meeting with worries but unlikely to have made any changes to my thesis. However, the full reply from Chris was “we continue to be comfortable with our forecast, but we have a ways to go.” Many executives use that last qualifier, but I have never heard Chris use it until that day. So by now alarm bells were going off in my head. If the market were still open, I would’ve been tempted to be rude, leave the room and jumped on Salomon Smith Barney’s hoot and holler to get the word out.

When the meeting ended, we thanked Ed and Chris for their time and left. While my clients and I were milling around the exit, it was clear to me only one or two of them understood what had transpired in that meeting. Most were portfolio managers, who were responsible for asset allocation of literally hundreds of companies. They were not familiar with the small nuances of the company let alone the executives.

I was supposed to fly to the West Coast after that meeting. However, I cancelled the trip and flew back to New York. I knew the next day was going to be extremely busy and I wanted to be in my office overlooking the Statue of Liberty as the barrage of investor calls and media requests poured in after I downgrade the stock at our morning meeting since I had been one of the most bullish in the sector.  When you know you are wrong, change your thesis ASAP!

The downgrade bled into the entire NASDAQ because the tech sector in hindsight had rolled over back in March. Investor’s were furious, including those at the meeting. Motorola’s largest shareholder, who was at the meeting, was livid because his conclusions were different from mine. That’s what makes markets fun. We all read many of the same tealeaves and come up with different conclusions. As an Equity Research Analyst on Wall Street, you need to know “How to Make a High Impact Call and When.” When you make that High Impact Research Call just keep in mind, you have to make four good calls for every bad call in the eyes of institutional investors.  Despite what you hear, downgrades are never popular with anyone unless they were short the stock.

My next post will be on a Longer-Term High Impact Research Call

P.S. I was very good at obtaining corporate meetings for many of my institutional clients. These could range from one-on-one exchanges to fancy bus tours with dozens of investors.  These types of trips helped institutional investors with their ownership positions, while corporate executives have an opportunity to hear from some of their largest shareholders. But, these small-group meetings can be a double-edged sword as illustrated by the Motorola meeting described above.

3 thoughts on “High Impact Research: Short-Term Example

  1. Another great article! I had a couple questions, though. You mentioned the time frame of May 2000 for the downgrade. It looked like MSI was already on a steep decline at that point. When did you first rate them at $200 and why? Additionally, what dynamics caused that spike around January 2000 (Y2K, etc.), and how did it impact your analysis in May?

    • Thanks for the kind words Bryan. Let me elucidate a bit and provide you with my opinions as I recollect them.

      The answer in hindsight is the tech sector had peaked earlier that year, but in the heat of the excitement we were not aware that was the case. Also, the March quarter is always a tough one to call in terms of balancing expectations and fundamentals. The first quarter is seasonally the weakest, especially for companies with infrastructure sales tied to telephone companies and a handset business tied to consumer sales. We all know it’s weak but we never know how weak.

      In addition, we believed the migration to 3G and the introduction of many services such as location-based applications introduced by companies such as SignalSoft and OpenWave would serve as powerful catalysts to drive infrastructure and handset sales. The growth, in our opinion, would lift all boats. We thought Motorola would get its fair share of infrastructure sales and weren’t going to make the same mistake in 3G handsets that they made during the analog to digital migration.

      Our thesis fell apart as pieces fell into place and after our meeting at corporate headquarters. 1) If an existing long-time customer were willing to essentially build a costly overlay or maybe even rip out their existing Motorola infrastructure, then maybe they will get less than their fair share after all. 2) One of the reasons the company was worried was because of component shortages that could either impact margins or delay the introduction of new products; 3) the first two essentially would cause them to miss not only our numbers but miss the Christmas selling season.

      We did not think they would miss the June Quarter but we were worried the December quarter could be a disaster. We just could not quantify it at the time because there were so many variables changing daily and the information we had was obviously always incomplete. Also, our price target was set near the end of the prior year if my recollection serves me right based on our assumption Motorola’s PE would expand as they prove they can deliver. Once we realized our estimate assumptions would be too high, we had to assume the multiple would actually contract.

      With respect to Y2K, it was an issue. We knew there was a lot of spending in anticipation of Y2K and that year-on-year comparisons would be tough. It was baked into everyone’s estimates, but it’s very different once everyone is actually facing the comparisons as quarterly results are released. The equity research analyst decision reminds me of a scene in 2001 Space Odyssey where the apes stand in front of a huge monolith trying to figure it out. Sell-side analysts are the same as those apes. They are barraged with information daily confirming or negating their thesis. 99% of the information is the same for every one. Just like the apes, we talk, scream and yell as we question our assumptions trying to figure out what to do.

      If you remember the movie, at some point, one of the apes walks around the monolith to figure out what is on the other side. It’s the same at the sell-side. At some point, one of us finds an innocuous nugget that let’s us figure out what we think is on the other side of the monolith. The monolith being the “rating.” Sell-side analysts aren’t traders so they can’t really change their ratings constantly. That would actually not make institutional investors happy nor the companies we follow. So the most difficult part of an Equity Research Analysts job is to figure out when to stick to your convictions and when to admit you’re wrong. Once you realize you are wrong, you just have to make sure you change your rating and estimates as soon as possible.

      I hope that helps.

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