Odd Lots - Inside the Changing World of the Sell-Side Analyst

Episode Date: October 2, 2017

The world of sell-side analysts has been upended in recent years with intense competition, new technology and regulation in the form of MIFID. At the same time, many of the issues being faced by the analyst industry are similar to the ones now faced by the media.On this week's episode, we talk to Steven Abrahams, the former head of mortgage bond and securitization research at Deutsche Bank AG, and now the co-founder and CEO of Milepost Capital Management, about his two decades of experiences in fixed income analysis. He talks about how his role has evolved over the years, what makes a good sell-side analyst and the parallels between the research industry and journalism.See omnystudio.com/listener for privacy information.

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Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you get your podcasts. Hello and welcome to another edition of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. So, Joe, what are we talking about today? Oh, yeah. Analysts. Wait, wait, wait. Before we get to that, can we just say this is not just another edition of the AdLotts podcast and that this is a special edition of the AdLot's podcast? Why is it special?

Because I am in the same room with you. I'm looking at your face as we're talking. normally we're in other studios around the world. Yeah. And so it was a very special moment where we happen to both be in the same city at the same time. So I just want to take a moment to appreciate how nice this is. I like how you say we're in the same studios when in reality I'm sitting on my living room floor. Right. I was trying, I didn't know if you wanted that information normally to get out there.

So I use that as a euphemism, but yes, normally I'm in a studio, you're in your living room floor. But this time, we're in the same studio about 10 feet away. Right. We are reunited and it feels so good, I guess. Okay. All right. But in all seriousness, let's get down to business. We are discussing a topic that I think is kind of close to both our hearts today,

analysts and analyst research. Yes. I don't think it's intuitively obvious when someone says, oh, analyst research is close to your heart. Maybe that's not the kind of thing that makes a lot of sense to people. But I think as people will see in the course of our discussion, for both of our careers, analyst research has played an important role. Absolutely. So I think a lot of people will have noticed by now that there is a significant segment of financial media that zeroes in on the cell side research being produced. And that kind of gives people ideas for stories or sometimes the stories themselves.

You write up an analyst note and it can be a big deal. And just so people understand when we talk about analyst research and the sell side, for those who don't know what those terms mean, we're talking about when you've seen those stories like Goldman Sachs is bullish on Tesla. Or Goldman Sachs upgrades Tesla to a buy. Or Morgan Stanley downgrades its forecast for the third quarter GDP or whatever it is. And you see those headlines. You see those stories. And that refers to the people at the big banks, typically, though not always, who write up reports on various things in markets in the economy that both, you know, traders and investors and, of course, journalists, we like to pour through it. So why are we talking about this today? All right.

So analysts and their research have been a big part of our lives. But at the same time, the industry has been going through its own, I guess, existential crisis and also business crisis in the same way that the media has struggled to monetize. the stories that we're producing. There's a similar question facing the analyst community right now. There's also a big, big change coming in the form of new regulation called MIFID, which is basically going to force the people that produce research to charge for it in a way that hasn't been done historically. And this is key. Lots of people get research reports for free because they trade with the bank and they give them commissions in that way.

and then the research is kind of a free bonus for them. Well, I've never understood the business of analyst research, like how analysts get paid, how banks make money on it. And I certainly don't understand what the new regulations are all about or what they're intended to do. So I'm very excited about this episode. Who are we going to talk to? All right. So we actually have one of my all-time favorite analysts. It's Stephen Abraham's.

He used to be head of mortgage bond and securitization research over at Deutsche Bank, but he recently left to go. found or co-found mile post capital management and he is now CEO over there as well. So shall we bring him on? Let's do it. Stephen, welcome to the show. Hi, Tracy. Hey, Joe. How are you? So maybe just before we begin, do you want to give a sort of analyst job in a nutshell kind of description? Well, I think a good analyst actually is probably a lot like any good journalist, really. You are always basically out there trying to chase the biggest possible story that you think might exist in your market. You want to get there first. You want to get there with the best information, and you want to deliver it with all the style you can muster. How you do that really depends upon what part of the

world you're focusing on. If you're an equity analyst, then you're trying to understand the latest about how your company's markets may be evolving or the strategies that you're rolling out. If you're in fixed income, which is where I've spent my career, then you may be focused on the economy. You may be focused on what the Fed is doing. You may be focused on specific twists in your own market. Mortgages have been mine, and you just want to get there first and get that information out to your audience. I have a feeling we're going to be talking about the parallels of journalism and being an analyst a lot on this because just hearing you talk, I already have so many questions. But one of the questions that comes up for a journalist is like, what is a job well done?

And so I'm curious for you what you during the course of your career have considered to be like a job well done. Is it having correct calls? Is it wanting people? Is it having people want to read your stuff first versus other analysts? Like when you look back and say, okay, I was successful at X, what are the, how do you benchmark yourself? Well, I think it's parts of both what you mentioned. I think the audience that you're speaking to desperately wants to be the first to know what is changing in their marketplace. And sitting on a trading floor or sitting at one of the larger banks usually gives you access to tremendous information flow.

That information flow can come through the traders because especially at larger places, they're seeing the various types of institutions that are buying and selling. It can come through the sales force who can often share information about the views of their clients, the kinds of assets that they may or may not be enthusiastic about. And you can often find in the midst of these streams of information little tidbits that you suspect are not broadly known in the marketplace. And those are the pieces of information that end up moving the market, essentially changing the price of one or a sector of assets when all other parts of the market for practical purposes may be standing still. That's the kind of information that can make or break an investment portfolio, and that's the kind of information that any good member of the byside audience wants to hear. So if that's the game, you really want to keep your ears open for those tidbits of information that you think signal things that could move the market. Sometimes they're small.

Sometimes they can be huge. And when you find that, that's a good day. That's a job well done. So I've always been curious. How are analysts perceived within sell side banks? Because externally, we in the financial media zero in on a couple like rocks. star analyst names like Peter Oppenheimer at Goldman or Marco Kolozsche at J.P. Morgan, do they have the same cachet internally or is analysts and analyst research viewed as basically

a cost center for the bank? Well, I think most firms, most firms, at least the places that I've worked, and I think this is just broadly true, recognize that good research and a good analyst just separates you from your competitors. If you imagine a market where there really were no good, aggressive, compelling analysts, then essentially you have a market where there is simply price execution that the bank could offer their clients. If the analyst brings good information or if the analyst is able to take lots of information, and synthesize it in a way that allows the audience of investors to understand and react to it, that's extremely valuable.

And it is a service that the bank can provide that many of their clients, in turn value, and over time will direct progressively more of their business towards the providing bank. And I think in a well-run institution, that, That's the way good research helps the investor and helps the bank. So your last answer there really gets to a question that I think a lot of people have about the business model. Because I let's say you unearthed some great nugget of insight. I want to trade on that. A, why can't I just go trade with a competitor use the information that you've provided me?

I have a big trade idea, go trade with a competitor, or maybe place a little bit of a trade through your bank to sort of show that, okay, thanks for that information, but then trade, do the bulk of my trading somewhere else. There doesn't seem to be a mechanism that naturally connects the bank that offered you the really compelling information and a reason to actually execute orders through that bank. Yeah, I agree. That has always been a problem with sell-side research. There's always the issue of free riders. I have never seen a completely satisfactory solution for it. I think a well-organized bank does have the ability to, roughly speaking, track and understand the proportion of the trading business that the account is providing to the bank.

And that is the best way of looking at the ability of the analytics. to help the bank generate trading revenue and effectively pay for the service provided. But it's a imperfect mechanism. So it's always been a problem. Talk to us, though, how the industry has changed over the years because there is a sense nowadays that analysts are facing a little bit of, maybe crisis is a strong word, but that they're struggling with this monetization issue. And it feels like that concern has been growing.

Has it actually changed? Well, I think that on the equity side, I think the change is clearer. And it seems like we're about to go into arguably a third chapter in the equity research model. I'd say the first chapter was pre-internet crisis, if you remember that one. And pre-internet crisis, equity analysts routinely had. special access to corporate management and what they learned in the course of those conversations often could be shared with a limited range of clients. And it was clear to the bank, it was clear to the clients, it was clear to the analysts that that was a clubby form of information flow.

after the crisis, I think regulation stopped that, which created, frankly, fairer markets. And the market is essentially operated in a post-Internet crisis mode until recently with the introduction in the EU, at least, of the MIFID regulations. And Mithid obviously is trying to put a very specific price on the provision of research. whether it will do that successfully is still to be determined. I contrast that, though, with fixed income research. I would say that in many respects, fixed income research, since it is often focused more on macro issues than on the particulars of a management team or a specific balance sheet, But fixed income research, at least in terms of its method, the way that it interacts with internal and external clientele, hasn't really changed as much over the years.

You know, obviously there's constant awareness of abiding by the evolving regulations that need to provide fair and accurate research. And there's always been an overriding, I think, premium attached to analysts that provide straight down the middle views of their markets. That's not always obvious, but still, I think the investing side has always been able to identify and appreciate those analysts. And the fixed income and the more macro side of the research enterprise has had much less. changed than the equity side. I think that that's still probably the case. I'm so glad we're having this conversation because now I'm remembering millions of questions I've always had about the business that I'm so that I've always wanted to ask someone. So here's your last answer. Why is it that by side clients need analysts to understand the markets that they're

that they're trading and that they're ostensibly getting paid quite a bit for to determine, you know, what the best stuff to buy and sell is. So in the fixed income space, if someone is a fixed income portfolio manager, what is it that you offer them or that fixed income analyst offers that it would be uneconomic for them to sort of understand themselves or put in the work themselves to figure out? Well, I would say the simple. example really is the place where I started my career, and that is in the mortgage space analyzing the behavior of homeowners that influence sometimes significantly the value of those securities. It's a market that's particular to the United States, but all mortgage

securities in the United States give the borrower the right to move, refinance, or otherwise pay their loan back early in most cases without any kind of penalty. So that creates uncertainty in the stream of cash flows that you would get from holding that security. And depending upon the nature of the security, how it's structured, those can have either minor, or or major influence on security value. That really is an exercise in gathering tremendous amounts of data and statistically modeling that data. So it is far more efficient for that activity to occur in a centralized place and for the results of that activity to be then delivered to clients, as opposed to having every single client separately aggregate the data and then do the statistical

modeling on their own. So that's probably the easiest case. I would also say that it's far easier for an analyst, even if an analyst is just trying to aggregate broad information about the types of buyers and sellers in a market, it's far easier for an analyst sitting on a trading floor to aggregate that information. than it usually would be for most by-side analysts. The sell-side analysts, in many cases, can literally walk up and down a couple of aisles, have a handful of conversations with sales representatives or traders that are interacting

with dozens of various accounts over the course of just, you know, that particular trading day and get a very clear read on what's happening. It would be a lot more work for a cell site analyst to collect that kind of information over the phone. Now, that's not always true. If you're at an extremely large asset manager, they would often have information flow, analysts, the ability to aggregate data, the ability to analyze that data, equal to, if not better than some of the sell-side shops. But shops that large are few and far between.

So the provision of that kind of information from the sell side, if you want to think of it this way, is really kind of a democratizing influence. It captures that information in an efficient way and that it spins it out into the marketplace in many cases for investors that would be too small and too focused on other things on their own to do it themselves. You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to your

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the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen. I want to go back to the media parallel for a little bit. Yeah. More navel gazing. Well, I don't think it's a secret that traditional journalism or media has struggled over the past few years, especially in light of the growing influence of the Internet, which has made news sort of more commoditized. So a scoop only exists for, what, five or ten minutes before someone else is disseminating it to the world?

Arguably one second. And it also means that you just have more competitors in a variety of forms. So I'm curious, when it comes to research, did you observe the same things? And how did you feel, for instance, if you wrote a really good note and someone like myself or Joe would immediately write it up at, say, F.T. Alphaville, my old employer, or Joe's old employer, a business insider? Well, I would say, in most cases, a good analyst loves the bullhorn of the media. You love to get magnified that way. In many, many cases, the first. The first. first recipients of your work are the institutions that are the clients of the firm. And they're typically going to get that information on direct distribution. There's nothing better than having that story picked up. In most cases, it won't be picked up immediately, but let's just say it's

picked up with some lag and then magnified in the broader press. It kind of sends a couple of messages to the clients of the firm. It says you really should pay attention when the information arrives because it's valuable. It's of interest to a broad audience. It has the potential to move the market and it gives you an opportunity to act on it. And it sends a broader message to entities that may not be dealing with your firm, that they're there are there's a good information flow a valuable information flow coming out of out of the bank so I think that ends up being a net positive in most cases in fact I I can't think of a case where a media follow-through wasn't good news on the things that I was working on or that my team was working on all right but

there are some perverse things that can happen in this cycle and so media often gets criticized for being hyperbolic or being a, you know, sensationalist. And I'm not going to name any names, but we all know that there are some popular cell side analysts who have been wrong on things for many years, predicting recessions, predicting crashes. And they're extremely popular. And they're really popular in the press because we like to write up bold calls. But they are completely everything, nothing they say ever comes.

to pass and I'm curious whether this media cycle, what? No, I don't need to name names, but whether this media cycle can encourage people to say provocative things that will get picked up in the press, but that aren't necessarily correct or grounded in good data. I think it does. I think it depends upon the market sector and who the analyst believes the audience is. if it is a retail audience, then you have to find a way of penetrating the same clutter as any other provider of information to that audience. And we all know that there is just a tremendous

number of channels that are fighting for the attention of somebody sitting in front of a TV in front of a broker's audience or somebody who is walking past the front of a store. If your audience is an institutional audience, it's not clear to me that the same approach works, because the institutional audience, if the institution ultimately needs to produce a return that will justify its fees. Genering that return is really hard work. That's what all the research shows, I think, in many ways, that's the story of asset flows of the last few years, that there is steady pressure on asset management fees. So you need to find sources of information that are thoughtful, reliable, actionable.

and if you're an analyst and you can provide that kind of information, then your audience is going to look for you rather than necessarily considering you as just part of the general clutter that comes over the wires. So we mentioned MIFID a couple times before, but this is the big European regulation coming in that's going to unbundle research from trading commissions, essentially. How do you think that's going to change the world of analyst research? Wait, before you answer, can you also explain why? Like, what was the situation? Because I don't even understand this still. So what was the situation that prompted the EU to think that this regulation was necessary

and then, of course, how that's going to change your world? I can't say that I know exactly what was in mind of the EU regulator. but I will happily read that crystal ball. So I would assume that what the regulator is trying to do here is unbundle trade execution from the provision of other services by a sell-side bank. And I suppose at some level you could say that that will create transparency in the marketplace because then you will be able to compare execution, as a separate service compared to research itself.

I don't know if we necessarily are going to see that result. In the U.S., we do not have at this point regulators taking the same view, so there is no effort so far in the U.S. to try to unbundle that. And I do have some questions about whether that will produce the amount of change that the EU regulators anticipate. One thing that seems relatively clear to me, though, is that it's more likely to have an impact on the by side than it will on the sell side. And the reason I suspect it could have an impact on the by side is that it will tend to favor institutions large enough to bear the separate cost of research. That provision of research, as I indicated earlier, in many ways is a really valuable democratizing influence.

Many small institutions that may not do a tremendous amount of trading with a cell-side bank still have access to the research flow. And once the sell-side starts requiring those institutions to pay for that provision of service, it might become prohibitive. It certainly, I can tell you that as somebody who is in the middle of building an asset manager now, you always keep your eye on costs and you're sensitive to the competition over fees that exists in the marketplace. And so if you have to pay additional fees to buy research, it's something that you're going to do very, very carefully. So my assumption is that at least for institutions,

that are dealing primarily in the EU or that fall under the EU jurisdiction, the rules are going to tend to favor concentration of asset management. In the U.S., those rules don't really apply, and so I think research in general is still going to be broadly available to a wide set of investors under the same protocols that have existed in the past, and so for the time being, provision of research in the model in U.S. markets, I think, is not going to change substantially. Yeah, this gets to another sort of business model parallel with media, which is that, you know, it's great to talk about, oh, we're going to restrict the provision of research and only if you pay for it, you get it. But as everyone knows, you know, there's, it's hard to stop people from

forwarding things, copying things, taking screenshots of things. Anyone in the news business has seen how difficult it is to put up paywalls. The music industry has seen how difficult it is to sell music as opposed to deal with piracy. Do people think that's realistic that shops that don't want to pay for it won't be able to surreptitiously get access to research? Well, I think you're absolutely right. My guess the old saying was information wants to be free. And the people who will be getting the research, I'm sure, will be quite careful to make sure that they don't violate their agreements with the sell-side institutions. But people talk at the very least. In many respects, information can be shared at the very least informally as part of just conversations with

colleagues and peers in the course of doing business. And if information circulates outside the purview of the MIFID rules, I'm not sure how you control the flow of that information if it comes outside and then goes back inside the EU jurisdiction. I understand the aspiration of the regulations and the desire to provide transparency. I just think, as you're pointing out, it's really hard to do it in practice. So a few people have commented that the era of analysts and analyst research is effectively dead. Do you agree with that statement? And how much can we read into your own departure from the analyst community, if you will?

Well, I wouldn't read too much into my own decision. I think that there will always be need for good information. I mean, that's what makes markets work. In fact, that in part was what I always found to be the most fascinating part about being an analyst. Information and good information really is the core of portfolio management, and it's the core of investing. And any good investor will tell you that a substantial part of their time and effort goes into getting their hands on good information and using it to make good decisions. So that will not go away. And so there will always be this core need for that information. And I suspect there will always be

analysts of some sort that are sitting in the chair and trying to generate and disseminate that information. So how it gets monetized may change. The nature of the distribution may change, but the core need for that information won't go away. I mean, it's impossible for a market to function without that. Speaking of the ways in which media is getting disrupted, we've seen a lot of sort of data journalism or people opening up their models and things like that are sort of like attempts to open source the gathering of news and stuff like that. Do you see that happening in your world, in your world where, you know, rather than a sort of pure research report, you're providing more tools to access the underlying data, things like that, basically just sort of

offering ways of giving people to manipulate and understand the news themselves? Well, I think those kinds of tools have really been certainly available in the fixed income world for decades. And again, back to my own little parochial playground, it was routine, starting in the late 1980s for the cell side to do the kind of data analysis and statistical work that I described and then post those models out for public consumption. Solomon Brothers was doing it, first Boston, which eventually became Credit Suisse, was doing it. And eventually, every shop that wanted to be considered a serious player in mortgage securities ended up with their own team of modelers and their own efforts to make the results of those models available. So I think that

has been out there for a while. There have been some private providers that have popped up over the years that have become real specialists in providing some kind of these central data sources. But I guess the broader idea of crowdsourcing information, I haven't seen that used in a way that I would consider really effective. I think the problem is that in any market, the value of information quickly degrades. And so if you genuinely believe that you have information that nobody else has and that it's information material enough to affect the information. value of an asset that you're buying or selling, you're going to use that information and transact on it long before you ever turn around and start telling your pals at the next shop. So by the time the information would get into a crowdsourced environment, I'm not sure it really has the zip

that it had when the first recipient got it. All right. Stephen Abraham, CEO and co-founder of Milepost Capital management, thank you so much for joining us today. Thank you, Tracy. Thank you, Joe. It was fun. So, Joe, I found that conversation fascinating, partially because, as you know, both of us have been so close to the world of analyst research for years now. Totally.

I mean, both of us sort of started our careers blogging, more or less. And a huge part of that was pouring through all the analyst research that would hit our inboxes, typically, especially at the beginning, through certain. superstitious sources, people who were not officially at banks. Now we're sort of more respectable. We get stuff from banks. But in the beginning, at least, I had to like, you know, mooch them from third-party sources, finding the analysts that had the interesting calls, writing them up, posting their charts. So actually learning more about how that business works is very enlightening. Yeah. And I guess it's kind of comforting as people in journalism to know that the issues that we struggle with everyone who handles information. information seems to be struggling with. And it's difficult because, as Stephen said, information is the

lifeblood of the industry. And yet, it seems so difficult to monetize that. Absolutely. And that tension between wanting to have, you know, as you said at the very end, information loses its value very fast. So the tension between wanting something out there, but also wanting to maintain that exclusivity is something interesting to hear about. We were talking before, but in my career in the beginning when we would write about sell-side research, often the banks would complain. They're like, oh, you didn't have the right to write about that. You weren't authorized to see that. And then two years later, those same people at the banks would, like, reach out and they'd say, well, why don't you ever write about our research anymore? So everyone is all navigating these

same back and forth tensions. I don't think there's, like, some clear answer about what the correct model is and how much to keep internal, how much to publicize, so forth. Yeah, exactly right. The same issues that we kind of struggle with. Others are struggling with, too. All right. Shall we call it a day on our information sharing? Let's leave it at that. And next time we'll be, next episode will be back to you on your, on your couch or on your floor. That's so sad. All right. Well, this has been a special edition of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway on Twitter. And you can follow me on Twitter at The Stalwart and follow our producer, Sarah Pets. on Twitter at Sarah Pat with two teas. Thanks for listening. I'm Francine Lacqua, an award-winning journalist, and I've got a new podcast, leaders with Francine Lacquois from Bloomberg podcasts.

I've interviewed everyone from heads of state to fashion icons about the news of the moment. But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision. Listen to new episodes every other Monday. Follow Leaders with Francine Lacroix wherever you get your podcasts.