The Direction of Independent Research in 2010

A variety of interesting topics were discussed today at The Sixth Annual Investorside Research Conference: Indepedents’ Day 2010 (sponsored by Bloomberg Tradebook and co-sponsored by the New York Society of Security Analysts) at Bloomberg’s headquarters, at 731 Lexington Avenue.

The challenges that have shaped the financial landscape within the last two years are still present. Nevertheless, several of the analysts who participated in the panel discussions agreed that these challenges also present opportunities for investors (primarily hedge funds and private equity firms) who are looking to enter the market with new positions.

There has been an array of regulatory and legislative initiatives but the truth is that research remains fundamentally central in the process of due diligence as well as in later stages of investment. The role of research has functionally persevered for about the last fifty years, it was argued, and its strength remains in the fundamentals. This means that all financial statements are crucially important and that more emphasis needs to be given to the study of the balance sheet. In contrast, think of the Internet bubble of the early 2000s, when analysts were satisfied with information on revenues and cash flows even if these were not giving a complete picture of the company’s health.

While analysts are returning to the fundamentals with a newly found rigor, investors are more willing to invest in equity rather than public/private partnerships because liquidity has become a big concern. No one wants to lock capital for the next ten years and with no provision of certain exit strategies. Equities by contrast offer a more manageable investment in terms of liquidity and timely exit. Analysts are still basing their due diligence for equities on strong fundamentals and they also expect the Fed to provide market surveillance, especially in the areas of interest derivatives, SWAPS, and CDS.

The flux of the financial landscape is evident in its own consolidation, an idea we discussed here in January (See: “Is Uncertainty the New Paradigm?”). It seems that this remains a major concern on everyone’s mind: there are 9000 banks in the US and five in Canada. The proper number of banks in the US is somewhere between 9000 and five, but five is a scary number for the American taxpayer because too few banks would imply that they are also too big to fail. This, in combination with a persistent weakness in risk management, implies that the consolidation in banking will continue within the next two years.

As for risk management, everyone’s trepidation stems from the realization that statistical models do not work and that contextual research is equally and even more important. It is time to think about the norms rather than mathematics. It is also time to think about who is on the managing team of a company, who is on the board, and who is the major player. The presenters unanimously agreed that qualitative research proves far superior to quantitative because behavioral economics must be taken into account.

The case studies presented at this conference confirmed the classic example of unrealistic expectations and bad accounting that leads to elevated risk for the shareholders. (Just to name a few of the companies elaborately discussed: First Solar, Q-Cells, Conergy, Suntech Power, Renewable Energy Corporation among others.) They all responded to unsustainable demand (demand based on temporary incentives to install solar panels for production of alternative power in European countries, mainly Germany and Spain), increased production, and tripled their inventory. This is where research on fundamentals can save shareholders from losses. In the aforementioned cases, growing inventory was coupled with growing receivables. When businesses were questioned what was happening with their balance sheet, the usual answer was that they were in the process of altering their business model. This, they claimed, was normal to show on the balance sheet, which should be excluded from analysts’ reports. Theirs was not a very plausible story, as we all know by now (the time frame of these cases studies was from 2006 to late 2008).

The only remaining issue with analysis of fundamentals and accounting in general is that US GAAP regulations are being tested. It was argued today that US GAAP might be soon going away to be replaced with IFRS rules. This may solve the problems of comparability and transparency within the global economy but also presents a tremendous conundrum for educational institutions with accounting departments. Accountants should definitely know how to work with both the US GAAP and the IFRS system but shaping the curriculum in schools is not an easy task while retroactively adjusting company records may be impossible.

Independent research has been strengthened by technological platforms such as LinkedIn and other forms of social networking, all of which become very useful tools for service providers looking to acquire industry knowledge and specific expertise. This combined with a renewed commitment to fundamentals and an interest in behavioral studies is where Independent Research stands in 2010.