What is a Buy-Side Analyst?

Thursday, March 14, 2019 | MarketBeat Staff
What is a Buy-Side Analyst?

Summary - In the world of capital markets, there are two kinds of equity analysts: sell-side analysts and buy-side analysts. Sell-side analysts are the researchers that have a public face. Their “buy”, “sell”, or “hold” recommendations are reported by financial news sources and a recommendation can move an individual stock or an entire sector. On the other side are buy-side analysts. While not as “well known” as sell-side analysts, they have an important role to play in the capital markets.

A buy-side analyst reports to fund managers at investment firms such as hedge funds, private equity firms, pension funds, or mutual funds. They conduct independent research that is different from the research that is provided to them by sell-side analysts. Their recommendations determine where a firm will invest their funds. This means that a buy-side analyst focuses on how profitable a stock can be. Risk management is an important part of their job as they have to be concerned with what can go wrong. A buy-side analyst’s research is not available to the public.

Buy-side analysts have an interdependent relationship with their sell-side colleagues. Much like a journalist relies on sources, buy-side analysts rely on the research from sell-side analysts because they generally have access to company executives and may be able to provide insight that can give buy-side analysts perspective on larger issues facing the company. Although a sell-side analyst’s primary responsibility is to “sell” their stocks to the buy-side analysts and their firms, their track record of delivering accurate forecasts can enhance their status in the eye of buy-side analysts.

The role of the buy-side analyst continues to change. Two areas that are giving buy-side analysts more to consider are the Markets in Financial Instruments Directive (MiFID II) that was recently issued by the European Union. This is changing the way that European firms receive research from their sell-side analysts (essentially it means that they must pay for this research which is given for free in the U.S.). Another issue is corporate governance which many firms are putting a premium on to help provide an objective look at issues that may cause a scandal at a company whose stock the firm is considering buying.

Introduction

Investors are taught to research the mutual funds, ETFs, or index funds that they are considering investing in. One of the most important metrics, of course, is the fund’s performance. And a fund’s performance has to do with its underlying securities. Portfolio managers rely on a group of professionals known as buy-side analysts to conduct proprietary research and give them buy recommendations or sell recommendations based on the fund’s investment objectives.

In this article, we’ll review the role of the buy-side analyst, review their role and responsibilities. We’ll also compare and contrast the buy-side analyst with the sell-side analysts that make recommendations to them in an effort to steer their investment dollars towards their brokerage houses or banking institution and explain how the two analysts work together in a mutually dependent working relationship. We’ll close the article with a look at how regulation is adding new considerations to the buy-side analyst’s role.

What is a buy-side analyst?

A buy-side analyst performs equity research for institutional investors that work for firms such as hedge funds, pension funds or mutual funds. They may also work for a private equity firm. The research that buy-side analysts provide is used by their portfolio managers to make investment decisions about where the fund should invest.  The information goes above and beyond the research, they receive from sell-side analysts.

Buy-side analysts make recommendations to portfolio managers at the investment firms they work for. The only objective of a buy-side analyst is to provide guidance on how profitable a particular equity may be to the fund’s investing strategy. For this reason, a buy-side analyst that is assigned to an aggressive growth technology fund will assign a different value to the FAANG stocks than an investor who is focused on a conservative income fund.

As important as it is for buy-side analysts to provide highly profitable (called high-alpha) recommendations to their portfolio managers, it is equally important for them to avoid providing bad recommendations. This makes risk management an important skill set for the buy-side analyst. They are looking at an investment through the lens of “what could possibly go wrong”?

While buy-side analysts do their work outside of the public eye, they influence capital markets because their recommendations lead to large orders to be placed which can move markets.

Responsibilities of a buy-side analyst

At first glance, a day in the life of a buy-side analyst would look fairly similar to that of a sell-side analyst (also called an equity research analyst). Both of them will follow financial news, track stocks, and tweak their models as needed. Buy-side analysts typically follow an entire sector (i.e. banking stocks, technology stocks, etc.) which means that at any given time they may have dozens of stocks that they are researching. A sell-side analyst may only be researching a handful of stocks. This is one distinction between the two kinds of analysts. We’ll take a look at other differences between these two analysts.

How is a buy-side analyst different from a sell-side analyst?

The success of a buy-side analyst is measured by their ability to make investment recommendations that profit the firm they work for. This is a critical distinction between a buy-side analyst and a sell-side analyst.

A sell-side analyst is representing firms (such as brokerage firms) that collect investment dollars from the firms that buy-side investors work for. Their objective is to market a stock offering to raise revenue for their firm. Their credibility is linked more to the access they have to the power brokers within a company than it is to their forecasts about future earnings and price targets being accurate.

A buy-side analyst, on the other hand, works where the money is. For this reason, their primary objective is to be right about their stock recommendations.

Another difference between buy-side and sell-side analysts is the availability of their research. Sell-side analysts are the talking heads that investors may see on financial news programs. Their research, which includes earnings forecasts, is typically released after the quiet period before a company’s earnings report is available to the public. On the contrary, the research done by buy-side analysts is exclusive to their firm. One reason for this is that many buy-side analysts use proprietary models to conduct their analysis. Portfolio managers are paying for access to these models and the buy or sell recommendations that come from it.

Why do buy-side analysts use research from sell-side analysts?

Because sell-side analysts typically research far fewer companies, they have access to research that is simply not available to buy-side researchers. This makes their research and recommendations an important component to the buy-side analyst. A helpful comparison may be between a journalist and their sources. Ideally, a source can help a journalist have access to information they may not otherwise have. A source can also help confirm speculation and rumors surrounding a company or its stock.

The usefulness of this research is measured in how much the buy-side analyst can gain insights into the inner workings of a stock. While this research is provided to investment firms for free, there is occasionally “soft money” paid to the brokerage houses and other firms that hire sell-side analysts. This money, which comes in the form of fees, is used as compensation for the sell-side analysts.

This practice of issuing soft money for research can raise questions about the underlying objectivity of investment analysts. After all, if a sell-side analyst has a close relationship with executives of the companies they cover, the thought is they could provide research that is overly positive about a stock and may issue a higher rating than what the stock merits. A lot of this concern has gone away due to regulation following the tech bubble crash of the early 2000s. A key regulation requires analysts to use commonly accepted valuation techniques in their analysis. So although they may use different models to dive deeper into a stock, the technique they use for their ratings should follow generally accepted accounting principles.

However, a more fundamental reason for sell-side analysts to provide ethical guidance is the importance of access. Sell-side analysts need access to buy-side analysts and the firms they represent. That access will only be possible if they are providing accurate information. If a sell-side analyst issues a buy recommendation on a stock that plummets based on a flawed analysis, the buy-side analyst will be less likely to use that analyst’s research in the future.

The role of regulation to a buy-side analyst

While regulation is not a big concern in the United States, buy-side analysts have growing concerns about the availability of significant research, particularly regarding small companies in Europe. This is because of the Markets in Financial Instruments Directive (MiFID II) recently issued by the European Union. MiFID unbundles research and transaction costs, effectively prohibiting the common practice of using "soft dollars" (which can be monetary or non-monetary) as an incentive for one party to trade with another. It also means that EU investment managers can only receive research from sell-side analysts if they pay for it. Not surprisingly, this is leading to a lack of research, particularly on smaller companies, a shrinking pool of sell-side analysts, and a tendency for some research to contain more "speculative hype" to set it apart from the research that a buy-side analyst could perform themselves.  

Another area where regulation is influencing the role of the buy-side analyst is in the area of corporate governance. The simple idea is that if more analysis is done about how a corporate board conducts itself it will make investment firms less likely to invest shareholders money into a company that is facing a scandal. However, more investors are becoming concerned about how companies address issues like executive pay, board diversity and even social issues like climate change. This has pushed many investment firms to hire corporate governance analysts who provide a "scorecard" for a company. This is another layer of information that a buy-side analyst will take into consideration when making a recommendation.

The final word on buy-side analysts

Buy-side analysts work for the portfolio managers at investment firms such as private equity firms, hedge funds, pension funds, and mutual funds. Although they work in obscurity compared to their sell-side colleagues, the recommendations made by buy-side analysts can move the capital markets when their firms make large buys or sell-offs on a particular stock.

A buy-side analyst is focused on how profitable a particular stock is to the investment objectives of their firm. They have much more at risk for getting a recommendation wrong and for that reason spend a considerable amount of their time focusing on what can go wrong with an investment.

Buy-side analysts are typically asked to cover an entire sector for their firm. Because they are stretched thin, they have a need for the research that sell-side analysts provide. This creates a reporter-source relationship between the two. And while the objectives of the two sides are different, it is in both parties’ best interests to ensure that they have a working relationship that is built on trust in the information they are sharing.

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