A Little Industry Experience May Make You a Better Analyst
Is an analyst with prior industry experience more likely to be on target with his earnings forecasts and stand a better chance of being named to Institutional Investor magazine’s All-America Research Team? In a word, yes.
At least that was the conclusion of a recently published study which examined the biographical data and earnings estimates of 2,590 analysts over a period of nearly three decades. Finance professors Daniel Bradley of the University of South Florida, and Sinan Gokkaya and Xi Liu of Ohio University undertook a comprehensive study of 112,973 earnings forecasts over the 1983–2011 period, and found that as little as one year’s worth of prior experience in an industry that an analyst was later charged with covering resulted in better outcomes for both the analyst and his or her clients.
Institutional Investor has long been surveying institutional investors on the importance of various attributes of sell-side research analysts, including industry knowledge, integrity and professionalism, and stock selection ability. Over the past decade, the survey has found significant year-to-year variation in the attributes most valued by fund managers; with one notable exception — industry knowledge. Industry expertise has consistently been ranked the most important quality a sell-side analyst has to offer those on the buy side.
Not All Experience Is Equal
It stands to reason that a research analyst might benefit from prior work experience in almost any industry. After all, core functions like product development, customer service, financial management, and strategic planning have similar applications across industries. But the authors distinguish between general experience and related-industry experience and, using the accuracy of earnings forecasts as their measuring stick, found that experience is beneficial only if it was in the same industry the analyst is covering.
The authors reported that the relative accuracy of forecasts issued by experienced analysts on unrelated firms is no different than those of inexperienced analysts. Specifically, the average relative forecast accuracy of analysts with related industry experience is 3.6% better than estimates by other analysts. Tracking the improvement of analysts’ estimates over time, the authors also found that the learning curve for analysts with related-industry experience was steeper than that for other analysts. In other words, their earnings forecasts became more accurate faster than that of their peers.
Industry Connections and Reg FD
The authors suggest that there are primarily two channels through which analysts’ related-industry experience might manifest itself. First, they can exploit the social network they developed while in industry. Former colleagues, suppliers, and customers can be important sources of information, though studies have shown that since the adoption in 2000 of Reg FD, which was designed to prevent the selective disclosure of material nonpublic information, any competitive advantage that social connections offered has been largely diminished.
An alternative explanation, according to the authors, is that previous industry experience gives an analyst a better understanding of an industry’s fundamentals, including business trends, competitive positioning, and regulatory and political risks. Since the accuracy of analysts’ earnings estimates were found not to have declined in the post-Reg FD era, the authors conclude that industry expertise, not a social network, is indeed the value-add that analysts offer.
Certain sell-side analysts can sway the direction of stocks with changes to their stock ratings and earnings forecasts, and the authors demonstrate that this market-moving influence is most pronounced in analysts with related-industry experience. In contrast, they found that the short-term price impact of forecast revisions from experienced analysts in unrelated industries is no different from that of inexperienced analysts.
Being named to Institutional Investor’s All-America Research Team is typically an annual goal for sell-side analysts and their firms. II-ranked analysts (“all-stars”) are reportedly paid 61% more than their unranked peers, and firms have been known to unabashedly campaign for their analysts so they can then boast about their celebrated roster of analysts to institutional investors and investment banking clients. The authors found that previous work experience marginally increases the chances of being named an all-star analyst, but only when the prior work is related to the industry being covered.
Prior experience in a related industry seems to lead to more accurate financial forecasts and greater influence, and it may offer sell-side analyst the quickest path to success and financial rewards. However, as my colleague Jason Voss, CFA, pointed out in “Advice on How to Become a Research Analyst,” there are other, often unconventional, avenues that can also lead to a successful career as an analyst.
Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.
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