Imagine for a minute that you’re a financial analyst at a hedge fund. You’re paid well, but you’re paid much, much better if you provide recommendations that outperform. How, then would you make those recommendations to perform as highly as possible to in turn be compensated as well as possibly?
A common misconception outside of finance is that the way to outperform is to do the best financial analysis. You know corporate structures better than anyone else, you read covenants and fine print clauses in debt agreements, you analyze the inherent FV of capital structures based on a firm’s current cash flows—in other words, you do everything that the CFA handbooks tell you to do.
This isn’t how you outperform. This is how you perform.
This kind of run-of-the-mill financial analysis is very hard, but it’s the bare qualifications to work in the industry. Analysts do not get big bonuses and bigger promotions because they’ve calculated the IRR of a corporate investment better than anyone else. They have to go deeper.
And this is where the analyst’s job gets a little fuzzy—and where the best analysts look like something else: journalists.
What’s a journalist’s job? The answer isn’t simple, but one possible answer is that the journalist uncovers things that no one else knows, but that other people should know. Since mispricings in capital markets are the result of information asymmetry—A knows something B does not—the journalist’s skillset can turn into a massive resource for investment outperformance if harnessed by the right investment firm. In fact, often hedge funds will hire journalists who have deep knowledge of an industry (say, a former video games journalist who knows how game releases tend to be received) to work as analysts covering that industry.
The best analyst, then, will teach himself or herself to become a journalist. And since the basic skills of finance are much harder and multifarious than those of the journalist—there is complex math, technical skills such as producing complex formulas in Excel, and many financial ratios and calculations to remember—it tends to be easier for the analyst to gain the skills of the journalist than vice versa.
So how does this work in practice? The analyst-as-journalist will go beyond the financial models and start interviewing people. Visit factories. Talk to managers. Ask buyers questions. Walk around the town. In short, become the newshound that is sniffing out information no one has discovered before, which you can then use to make a major long or short investment on a stock.
A fine example of this in practice would be the case of Sino-Forest. In 2011, Block’s firm Muddy Waters wrote extremely detailed and well-researched reports arguing that Sino-Forest was, essentially, a fraud. The company went bankrupt the next year, and in desperation sued Muddy Waters the next year for defamation (the case went nowhere).
The entire story is riveting stuff; even the Wikipedia entry is an engaging story of intrigue. But the point of the story is that, in this case, Block’s firm went from simple financial modeling to on-the-ground sleuthing to uncover facts that were not well known about the company.
One does not have to go to a Canada-listed Chinese company for such opportunities. Similar cases of deep sleuthing uncovering material facts has resulted in successful investing of many companies, even the biggest like Amazon, Apple, and Google. The key is for the analyst to go beyond the spreadsheet and onto the streets, to find out what’s really going on in the real world.