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How Merrill beat peers in treacherous Asian markets

In Asia's increasingly treacherous stock markets this year, Merrill Lynch's research team has found that discipline – and a willingness to be bearish – has paid off for its clients.

"We have a fairly disciplined process to make sure the analysts' views are current and they're challenging their own views continually," said Hunsoo Kim, head of Asia-Pacific research for the big U.S.-based firm.

Merrill's approach – which includes a requirement that all analysts rate at least 20 per cent of their coverage list in the "underperform" category – has helped lift the firm to the top of market analytics service StarMine Corp.'s rankings of the 25 biggest pan-Asian equity research teams, based on the 12-month returns generated by the stock recommendations of its analysts. The firm also boasts the highest proportion of its analysts with four- or five-star StarMine performance ratings (five is the highest score), with 37 per cent.

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StarMine ranks brokerage firms using a proprietary scoring system called the coverage adjusted score – which assesses the performance of each of the firm's stock recommendations relative to the overall results for all the stocks in each sector, then adjusts the results to compensate for differences in the stocks actually covered by each firm. In this case, the system compared each stock's performance over a local benchmark – the same sector in the same country of origin – so that country-by-country differences in overall sectoral performance are removed from the equation.

The system uses each firm's stock recommendations to emulate a "long-short" investing strategy – mimicking the effect of going long on stocks rated "buy" and shorting the stocks rated "sell". This way, firms get credit for both "buy"-rated stocks whose returns exceed the overall sector, and "sell"-rated stocks which underperform their peers. (Stocks rated "strong buy" or "strong sell" are awarded double credit; ratings of "hold" or "neutral" receive no score.) From this, StarMine generates a score that, essentially, represents a standard-deviation degree by which each firm has outperformed or underperformed the overall market. (Positive scores are outperformance, negative scores underperformance.)

Tim Gaumer, director of fundamental research at Thomson Reuters, which operates the StarMine service, noted that Merrill's Asian team has particularly excelled as market conditions have deteriorated this year.

"As things got tougher, they moved up the ranks," he said.

Mr. Kim believes that Merrill's insistence that its analysts maintain a significant portion of their coverage as "underperforms" – which are treated as "sell" ratings by StarMine's scoring system, even though for Merrill they are meant to signify stocks that it believes will generate inferior returns relative to their sector peers, regardless of whether they are expected to go up or down – hurt the firm's rankings during 2009 and 2010. For much of that period, markets were rallying and even many underperforming stocks were putting in solid returns. But "that environment pretty much evaporated about three months ago" in Asian markets, he said - and now, Merrill's insistence on identifying underperformers is paying off for its clients.

"Not everything can be a buy," he said. "[Our]analysts are always actively looking, in terms of pecking order and downside risks to their stocks."

Mr. Kim added that Merrill has worked hard to upgrade its pool of talent among its analysts in the past two years. "That has resulted in better recommendations for our clients," he said.

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Merrill's disciplined approach also includes a committee of senior analysts that reviews its analysts' stock recommendations regularly and requires them to explain and defend any rating changes; and a requirement that analysts always identify price targets for the stocks they follow.

"With all that in place ... it lends itself to a disciplined way of looking at stocks," he said. "We believe that what we're trying to do here is the right thing to do."

Merrill's coverage-adjusted score for the past 12 months is 1.22, well ahead of second-place CLSA, at 0.84. These scores are somewhat low compared with what top-ranked firms have been posting since the market recovery began in 2009 - evidence of how much more difficult it has become to pick winning stocks in the current environment.

"It appears to be getting harder to add value as a stock picker in this market," Mr. Gaumer said.

He noted that in 2009, 20 of the 25 biggest firms in the region posted positive coverage-adjusted scores - meaning their recommendations beat the benchmarks, adding value for clients. But this year, only three of the 25 firms have positive scores - led by Merrill Lynch.

"The market has become less predictable," Mr. Gaumer said. "It may not be reacting to the kind of fundamentals that analysts typically focus on."

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Mr. Kim said that with risk aversion reigning over stock markets as long as the European debt situation remains unresolved, Asian equities could remain under pressure, despite the relatively strong growth prospects among the predominantly emerging-market economies in the region.

"In a risk environment, people tend to prefer developed markets," he said.

He said that given the European uncertainties and the slowing global economy, "We're still emphasizing the defensive" in the firm's investing recommendations.

"We like the Asian consumer as a general theme," he said, noting that Asian consumers carry much less debt than their Western counterparts. He added that domestic-focused Asian consumer stocks also steer clear of the export-related businesses that stand to be hurt by sluggish demand from developed economies.

Longer term, he said, Asian stocks in general look poised to outperform their global counterparts once Europe's crisis is resolved.

"Asia is trading at a very low multiple, and it offers superior growth," Mr. Kim said.

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About the Author
Economics Reporter

David Parkinson has been covering business and financial markets since 1990, and has been with The Globe and Mail since 2000. A Calgary native, he received a Southam Fellowship from the University of Toronto in 1999-2000, studying international political economics. More

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