| Illustration by Jasu Hu. |
At the start of 2016, when portfolio strategist Yin Luo recommended that his clients exercise caution, he was not exactly the Lone Ranger among analysts.
Pretty much everyone was alarmed by the state of U.S. stock markets, which were nearly in free-fall as a result of China’s economic turbulence and plunging oil prices. Describing the treacherous environment as “risk off,” Luo — who worked for Deutsche Bank Securities at the time — advised investors to stick to defensive stocks in domestic utilities and health care sectors.
“My call was that the market was more likely to sell off before it recovered,” he recalls.
But then Luo issued a boldly contrarian call. Even as investors were reckoning with an orgy of selling, he declared in mid-February that the tide had turned and the macro environment was now “risk on.” He urged shell-shocked investors to dump defensive stocks in favor of basic materials, consumer cyclicals, financial services, and real estate.
| Research & Rankings The Leaders Weighting the Results Hedge Fund Leaders Versus All-America Research Team Hedge Funds’ Favorite U.S. Equity Research Analysts |
In anticipating the March rally, Luo’s timing was nearly perfect. Investors able to go long on low-volatility stocks while shorting high-risk stocks in January and February, then pivot in March and take an opposite tack, would have realized a 35 percent return through June (when Luo’s tenure at Deutsche Bank ended).
“The problem for the U.S. equity market since the 2008 global financial crisis is that it has been dominated by macro events,” says Luo, who joined Wolfe Research in October. “Picking the right stocks is no longer sufficient. Rather, successfully predicting risk-on/risk-off regimes seems to be all that matters.”
Luo’s ability to marshal mountains of data and give early notice on where markets are headed has endeared him to hedge fund managers. One fan is Kevin Shea, chief executive at Disciplined Alpha, a Boston-based hedge fund firm, who extols Luo as a practitioner of the “new analytics.” Since 2008, Shea has invited Luo to speak at investor conferences about “regime investing” — Luo’s contention that fundamentals are almost irrelevant in a macro environment. “What’s amazing about Yin is not just the high quality of his work, but the quantity,” Shea says. Yang Lu, a portfolio manager at alternative-investment firm BlueMountain Capital Management, adds, “He’s someone on the frontier of new ideas.”
That work ethic, coupled with a willingness to go against the grain, explains why Luo is the No. 1–ranked portfolio strategist in Alpha’s annual ranking of hedge funds’ favorite sell-side analysts. To determine hedge funds’ preferred research providers, Alpha recalculated the results of Institutional Investor’s 2016 All-America Research Team ranking of the top sell-side equity analysts in the U.S., using only the votes cast by hedge fund respondents. The results reflect the opinions of 1,217 hedge fund managers at some 450 firms that collectively manage about $1.22 trillion in U.S. equities. The table beginning on page 41 cites the analysts who finished in first, second, and third places in each sector, plus runners-up (where applicable).
| Hedge Funds’ Favorite U.S. Equity Research Analysts Basic Materials Capital Goods/ Industrials Consumer Energy Financial Institutions Health Care Technology, Media & Telecommunications Economics & Strategy |
Although there was much overlap between Alpha’s results and the All-America Research Team this year, there were 20 sectors — as disparate as Airlines, Banks, Internet, and Media — in which sell-side analysts who emerged as hedge fund favorites had finished behind the top winner in Institutional Investor’s overall rankings. Luo, for example, ranked as a runner-up in Portfolio Strategy in the main poll (while ranking as a first-teamer in Quantitative Research in both surveys).
Sell-side analysts insist they provide top-notch research for all their clients. Says Benjamin Swinburne, a Morgan Stanley analyst ranked No. 1 by hedge funds for his coverage of both the Media and the Cable, Satellite and Telecom Services sectors, “There’s no bright line between my approach for hedge funds versus traditional funds.”
Yet hedge funds do have a set of research requirements that are different from those of their long-only counterparts. Although hedge funds come in many sizes, shapes, and investment styles, one common trait they share is their appetite for what P. Carter Copeland, an aerospace and defense industry analyst at Barclays, calls p“a high velocity of idea generation. There’s pressure to come up with unique ideas for clients who want to allocate capital quickly.”
Hedge funds, of course, differ most sharply from traditional asset managers in their ability to short stocks. Kenneth Usdin, a midcap bank analyst at Jefferies, says hedge fund managers always want to understand “both sides of the story. Even when you’re recommending a name, they want to hear the bear case. They want the same stuff as a long-only investor — insights into a company’s performance and access to management and attention to detail — but they also want to understand where investor sentiment is directionally and if a stock is crowded.”
Moreover, hedge fund investors appear drawn to analysts who have exceptional personal qualities or boast job experience that gives them an edge. In that sense, hedge fund managers like equity analysts who are a lot like them: smart, contrarian, and prone to turning over every rock to find the best investment ideas. (Indeed, UBS’s Eric Sheridan, Alpha’s No. 1–ranked Internet analyst for the third straight year, used to work for two hedge funds.)
Jeffries’s Usdin worked at the Federal Reserve Bank of New York before moving to Wall Street. Luo, who also ranks No. 2 with hedge funds as an Accounting and Tax Policy analyst, spent a year working for accounting firm KPMG. J.P. Morgan airline analyst Jamie Baker once structured airfares at Northwest Airlines Corp.
Then there’s UBS’s Sheridan, who toiled for a decade as a portfolio manager at hedge fund firms Citadel and Intrepid Capital Management before, he says, suffering a case of “burnout” and exiting in 2012. The next year UBS gave Sheridan, who also holds a law degree, the chance to work as a sell-side analyst following Amazon.com, Facebook, Google, and other Internet companies “to see if somebody with my background would resonate with clients.”
So far, so good. Sheridan’s clients praise his extensive channel checks and industry contacts. “He knows a tremendous number of people who provide him with more than scripted, cookie-cutter answers” from top management, one source says.
Sheridan’s specialty has been finding unrecognized value in out-of-favor stocks. Consider his unpacking of eBay, viewed as “a stodgy, 1.0 Internet stock like Yahoo!, Yelp, and AOL,” remarks a portfolio manager. After the online auctioneer announced in 2014 that it would spin off PayPal, Sheridan pored over its divisions, holdings, and properties. His view in June 2015: eBay was undervalued by at least 13 percent. That prompted him to raise his target price for the shares, which were trading at $62.01, to $70. (The company’s shares subsequently rose to $66.29 on July 17, 2015, when PayPal was divested.)
Equally useful, investors say, was Sheridan’s depiction of eBay as a company reinventing itself, modernizing smartly, and scaling up to accommodate millions of online customers — so much so that “technological improvements meant better consumer experience, greater usage, and more sales,” says the unnamed portfolio manager.
Blessed with Sheridan’s buy rating and minus PayPal, eBay opened at $26.89 on July 20, 2015, its first day of trading postsplit. It outperformed the market handily, gaining 20.9 percent through October 19 of this year (although the stock has cooled somewhat since then, trading at about 6.5 percent above the July 20 opening price as of early November). Nevertheless, Sheridan retains his buy rating.
Meanwhile, Sheridan reports that his eBay work excited a flurry of investor interest. “We had a lot of incoming calls from value investors and special-situation investors whom we normally don’t see,” he says.
Morgan Stanley’s Swinburne is another analyst whose work has particularly resonated with hedge fund voters. One hedge fund client says of Swinburne, who has logged 16 years of experience: “He’s definitely the best media analyst. He thinks for himself, he’s not dogmatic, and his views are data-driven.”
These traits were most evident in early 2015, when Swinburne unexpectedly slashed the media sector’s rating to cautious from attractive. The analyst tells Alpha why, after being such a raging bull, he soured on a basket of 15 media stocks that included such familiar names as 21st Century Fox, Time Warner, Viacom and Walt Disney Co. During the previous three and a half years, the sector had thoroughly outdistanced the market, achieving a 110 percent weighted average return, Swinburne notes, compared with the S&P 500’s more terrestrial 45 percent performance. But, Swinburne contends, the cable bundle had come under additional pressure. Customers were dropping channels, television advertising had matured and faced new competition from online platforms, and potential mergers and acquisitions “were not a good reason to be overweight.”
The bottom line? From the January 20, 2015, downgrade through November 11 of this year, Swinburne reports, the media sector declined by 2 percent, compared with the S&P’s advance of 7 percent. Asked how his clients have reacted, he says, “You get a thumbs-up when your stock calls work.”
Barclays’ Copeland also gets high marks from clients for his willingness to take an unpopular stand. “I haven’t been afraid to make counterconsensus calls when I have conviction,” he says.
Consider his downgrading Lockheed Martin Corp. to underweight at $226.43 on November 30, 2015. The stock call was not greeted warmly: After nearly three years of sector outperformance, Lockheed was an investor darling. As Copeland, whose background includes work as a Fed economist, acknowledged in his report, “There’s a lot to like” about Lockheed, including its stellar management team, size, liquidity, and reputation “as a safe haven for investors.”
Nonetheless, Copeland saw significant challenges. Among them: The company faced dilution from its $9 billion acquisition of Sikorsky Aircraft (maker of the Black Hawk helicopter), while both earnings estimates and valuation were, in his view, inflated. Copeland reports that many of his concerns have been borne out since the downgrade, with the stock dipping by as much as 13 percent at one point. And although Lockheed stock had snapped back to $230 in late October, he says, “it’s underperformed its peers.”
Veteran airline analyst Baker is highly esteemed for helping J.P. Morgan clients make sense of the welter of industry data and activity, including “fare increases, airline schedules, competitive skirmishes in various cities, labor negotiations, and fuel hedging dynamics,” says one hedge fund source.
Like many analysts early this year, Baker was bullish on Spirit Airlines. A new chief executive, Robert Fornaro — a former CEO of AirTran Airways, with broad industry experience — had taken over Spirit’s cockpit and was promising to shore up sagging revenue. He was also vowing to provide passengers with a kinder and gentler experience, and to regain investor confidence. Baker launched coverage of the stock on January 14 with an overweight rating at $36.50 and a $52 price target.
Fornaro’s charm offensive appeared to work. But after shares sprinted to $52.96 and gained 46 percent by April 20, Baker downgraded Spirit to neutral. The stock remained “a consensus long,” Baker notes, “but we felt shares had gotten ahead of themselves on assurances from management that the carrier was going to overhaul its operations.” Shares, he adds, “are currently resting in the low $40 range.”
For the record, Baker’s upgrade and downgrade were made at the low and high points for the stock so far this year. That should keep his clients coming back for more.
