The thought processes of analysts change with time as we get experienced and learn from our mistakes. This is a natural progression even though people will definitely progress to higher stages at different times. Some unfortunate ones will however never progress to the higher stages. Based on my personal experience and books that I read here is my take on the three different stages of an analyst.
The beginner analyst is usually a fresh graduate with some background of finance, economics or accounting. Even though he or she might have some theoretical knowledge of finance, they seldom can relate the theory with the practical world.
The beginner will almost always put the greatest emphasis on NUMBERS and not the story behind the numbers. Thus there will be a tendency to extrapolate past performances as that will form the strongest basis for future forecasts. Thus we will see that future gross margins are just continuation of the most recent reported gross margins.
In the absence of proper guidance from seniors other mistakes will also be made. For example, there could be forecast of significant revenue growth without the required capital expenditure.
The beginner might also at times be over-conservative. To overcompensate for the lack of experience he or she might at times use too low a growth rate or bottom of the cycle margins. Thus the inability to distinguish between a great and an average company will push the beginner towards companies which are trading at very low headline price multiples.
The intermediate analyst will learn to avoid many of the common mistakes that the beginner will do. He will learn that the numbers by themselves really do not make much sense. To be able to deliver true insights into the future one must focus on the BUSINESS MODEL and the STORY behind the numbers. A lot of time will thus be dedicated to understanding industry structures, competitive situation, position of products, competitive advantages etc. He will understand the difference between cyclical industries and defensive ones. The difference between a capital heavy business model and a capital light model. Most importantly he will be able to relate these things to the real numbers.
The intermediate analyst will also become well versed with the logic behind valuation. The common mistakes of forecasting not enough ‘capex’, or having unsustainable working capital inflows etc will be avoided. He will be able to visualize how and where the financial forecasts relate to the valuation. For example, the fact that terminal year ‘margins’ and ‘capex’ play a big role in valuation will be noted with care.
This is also the stage where the industry contacts are made. Instead of just relying on the same common sources, the analyst will gradually learn to gather insights from various sources like competitors, customers and suppliers. He will however not be able to re conciliate the contrary views provided by various sources.
The intermediate analyst will start realizing that business qualities vary greatly. Between industries and within industries there are excellent businesses as well as very poor ones. However, he might be unable to clearly decide how much premium a great business should have over an inferior one.
While most analysts can eventually jump to the intermediate level from the beginner level, the advanced level is something very few can go to. The advanced analyst knows that along with the numbers and the business model it is very important to know the top management and the major owners. He will do extensively background checks to ensure that the owners and the top management are people of high ethical standards and will not harm the minority investors. Time will be dedicated to scrutinizing the capital allocation decisions like dividends, buy backs, expansion projects. Special attention will be given to see related party transactions.
The main differentiating factor of a great analyst is that he will be able to quickly find the key variables that will decide whether an investment opportunity is a buy or sell. Years of experience and a sharp brain will help him make quick decisions even when 100% information is not available.
He will go into a management meeting and not only know the right questions to ask but also the right way to ask them (so that most insights can be gathered). These insights will be combined with the ones gathered from all other stakeholders to prepare a convincing thesis.
The advanced analyst will also know how much he is willing to pay for a great business. He will be able to buy great businesses at discounts to fair value when markets will temporary misprice them for technical reasons or overreact on negative news. He will be able to differentiate between ‘value traps’ and true turnaround cases.