Buy side research

What Is Buy Side Research?

Buy side research refers to the investment analysis conducted by financial professionals who work for firms that purchase and manage assets for their own accounts or on behalf of their clients. This type of research falls under the broader category of financial analysis and is primarily driven by the objective of identifying profitable investment decisions for the firm's portfolio. Entities engaged in buy side research include asset management companies, hedge funds, mutual funds, pension funds, and other institutional investors. Unlike sell side research, which aims to generate trading commissions or investment banking fees by providing recommendations to external clients, buy side research is conducted internally to inform the firm's proprietary trading or client portfolio management strategies.

History and Origin

The origins of sophisticated investment research on the "buy side" are intertwined with the growth of institutional investing in the mid-20th century. While individuals traditionally dominated stock ownership, the post-World War II era saw a significant rise in pension funds and mutual funds. These collective investment vehicles required dedicated expertise to manage their growing pools of capital. Initially, much of the research relied on manual data collection and analysis. As the market became more complex and the volume of assets under management expanded, the need for specialized, in-house research capabilities intensified. This evolution saw the role of the analyst transform from a "green-eyeshade statistician" to a pivotal figure in finance, particularly as institutional investors began to seek more targeted and impactful insights for their burgeoning portfolios.⁴

Key Takeaways

• Buy side research is conducted by financial institutions that manage money for their own portfolios or for clients, such as asset managers, hedge funds, and pension funds.
• The primary goal of buy side research is to generate actionable insights and recommendations that directly inform the firm's investment decisions.
• Buy side analysts typically focus on long-term investment horizons and possess a deeper, more specialized understanding of the companies or asset classes they cover.
• Research output is generally proprietary and confidential, not distributed publicly.
• Compensation for buy side researchers is often tied to the investment performance of the funds they support.

Formula and Calculation

Buy side research does not adhere to a single, overarching formula, as it encompasses a broad range of analytical activities. Instead, buy side analysts utilize various valuation models and analytical techniques depending on the asset class, industry, and investment strategy. These might include:

• Discounted Cash Flow (DCF) Models:

  $$PV = \sum_{t=1}^{n} \frac{CF_t}{(1+r)^t} + \frac{TV}{(1+r)^n}$$

  Where:

  • (PV) = Present Value
  • (CF_t) = Cash Flow in period (t)
  • (r) = Discount Rate (e.g., Weighted Average Cost of Capital)
  • (TV) = Terminal Value
  • (n) = Number of periods
  • This formula is used to estimate the intrinsic value of a company or asset by projecting its future cash flows and discounting them back to the present.

• Relative Valuation (Multiples Analysis): Involves comparing a company's financial models and metrics (e.g., Price-to-Earnings, Enterprise Value-to-EBITDA) to those of comparable companies or industry averages to determine its relative value.

• Financial Statement Analysis: A comprehensive review of a company's income statement, balance sheet, and cash flow statement to assess its financial health, profitability, and operational efficiency.

The selection and application of these methodologies are tailored to the specific investment mandate of the buy side firm.

Interpreting Buy Side Research

Interpreting buy side research involves understanding that its primary purpose is internal and action-oriented. Unlike sell side reports, which often provide broad "buy," "hold," or "sell" ratings to a wide audience, buy side research delivers granular, in-depth analysis directly to portfolio managers and investment committees. The insights gained from buy side research are highly specific to the firm's investment philosophy, risk tolerance, and asset allocation strategies.

An analyst's conclusion within buy side research might not be a simple target price, but rather a detailed thesis on a company's competitive advantage, a nuanced understanding of industry trends, or a complex scenario analysis related to a specific fixed income security. The focus is on finding an information edge to generate alpha, or excess returns, for the firm's funds. Therefore, the interpretation emphasizes the actionability of the research – how it directly informs the purchase, sale, or hedging of a security. The thoroughness of due diligence in buy side research aims to uncover insights that may not be widely known or understood by the broader market.

Hypothetical Example

Consider an asset management firm specializing in technology stocks. A buy side analyst at this firm is tasked with researching "Tech Innovations Inc." (TII). The analyst performs deep dive equity research, going beyond publicly available quarterly reports.

1. Data Gathering: The analyst collects TII's financial statements, competitor data, industry reports, and conducts interviews with industry experts and TII's suppliers.
2. Model Building: Using this data, the analyst constructs a comprehensive financial model for TII, projecting revenues, expenses, and cash flows for the next five years, including sensitivity analyses for various economic scenarios.
3. Valuation: Based on the model, the analyst determines an intrinsic value per share for TII, which is significantly higher than its current market price. This suggests TII is undervalued.
4. Qualitative Analysis: The analyst also assesses TII's management quality, patent portfolio, competitive landscape, and potential regulatory risks. They conclude TII has a strong competitive moat due to its proprietary technology.
5. Recommendation: The analyst presents a detailed report to the firm's portfolio managers, recommending a significant allocation to TII for their growth equity fund, outlining entry points and potential catalysts based on their buy side research. The portfolio managers then make the final investment decision, using this internal research as a core input.

Practical Applications

Buy side research is critical across various facets of the financial industry, informing the core activities of investment firms. Its primary application lies in supporting direct investment decisions for proprietary trading desks and client portfolios. Analysts in these roles conduct in-depth equity research or fixed income analysis, building sophisticated valuation models to identify mispriced securities or attractive investment opportunities.

Furthermore, buy side research plays a vital role in portfolio construction and risk management. By generating unique insights, these teams aim to achieve superior risk-adjusted returns compared to market benchmarks. For institutional investors like pension funds and endowments, rigorous buy side research ensures that investment strategies align with long-term liabilities and funding objectives. The professional certification of financial analysts, such as those with the CFA designation, further underscores the importance of robust research skills in these roles. I³n the United States, investment advisers, including many buy side firms, are regulated by the Investment Advisers Act of 1940, which mandates fiduciary duties and disclosure requirements.

²## Limitations and Criticisms

While buy side research is integral to successful investment management, it is not without limitations. A key challenge is the potential for confirmation bias, where analysts might unknowingly seek out or interpret information in a way that confirms their pre-existing beliefs or the firm's current portfolio holdings. This can lead to a less objective assessment of an investment.

Another limitation stems from the sheer volume and complexity of information available. Even with dedicated resources, a buy side team cannot cover every potential investment in the same depth. This often necessitates a focus on specific sectors or geographies, potentially leading to missed opportunities outside their immediate coverage universe or a less comprehensive understanding of broader market efficiency.

Additionally, the reliance on external data providers and, at times, external (sell side) research, can introduce dependencies. While buy side research aims to generate proprietary insights, analysts may still consume information from various sources. Some observers note that even with the best intentions, the relationship between buy-side and sell-side analysts can be complex, with considerations around management access and potential for bias in external reports. T¹he proprietary nature of buy side research also means that its methodologies and findings are not subject to public scrutiny, which could limit external validation or independent critique.

Buy Side Research vs. Sell Side Research

Buy side research and sell side research differ fundamentally in their objectives, clients, and incentives within the financial institutions landscape.

While both sides conduct equity research and fixed income analysis, the "buy side" uses research to make investments, whereas the "sell side" uses research to facilitate investments for others.

FAQs

What types of firms conduct buy side research?

Asset management firms, hedge funds, mutual funds, pension funds, endowments, and family offices are common examples of firms that conduct buy side research. These are typically institutional investors that manage significant capital.

How is buy side research different from sell side research?

The key difference lies in the objective. Buy side research is conducted internally to inform a firm's own investment decisions and manage their clients' portfolios, with the goal of generating investment returns. Sell side research, on the other hand, is produced by brokerage firms and investment banks to provide recommendations to external clients, often to generate trading commissions or support investment banking activities.

Is buy side research publicly available?

Generally, no. Buy side research is considered proprietary and confidential. Its value lies in providing an informational advantage to the firm that conducts it. Unlike sell side reports, which are widely distributed, buy side analyses are typically for internal use only to inform specific investment decisions.

What skills are important for a buy side research analyst?

Strong analytical and quantitative skills are essential, including proficiency in financial models and valuation models. Critical thinking, deep understanding of specific industries or asset classes, and excellent communication skills to present research findings effectively are also crucial. A solid grasp of accounting, finance, and economics forms the foundation.