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Original thinking in analyst reports: The only 'buy' worth reading

Chris Umiastowski is the growth investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

In last week's column, I wrote about the value of reports written by equity analysts working for brokerage houses. I had suggested that you ignore stock target prices and recommendations as well as any analysis pertaining to the short-term performance of a stock. I told you to focus only on value-added analysis pertaining to the longer-term performance of a particular business or industry.

From the e-mail replies I received, I can tell I need to clarify one point about analysts: Most analysts don't publish conclusions that they believe are false. They aren't out to mislead you. I've encountered very few analysts whom I felt were dishonest at the core. It's just that analysts are expected to publish a lot of reports because they cover lots of stocks, and writing reports is part of their full-time job. Because they are expected to have something to say about any piece of news, they get stuck writing a lot of reaction pieces, which distract them from conducting and publishing pro-active research.

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But when analysts are able to produce pro-active research, it can be immensely helpful to their clients and to amateur investors who happen to get their hands on these reports. As a growth investor, I love research that helps me understand whether a company's growth will significantly exceed or fall short of whatever the stock price implies. The key word here is "significantly" because I'm looking for stocks where expectations several years out are way off the mark.

As an example, I remember reading various analyst reports on the smartphone industry in 2011. Some of the smarter analysts pointed out that Nokia still controlled close to 35 per cent of the cellular phone industry despite having a horribly weak position in the smartphone market. Windows Mobile wasn't going anywhere (yet) and Nokia's legacy operating system, called "Symbian", stood no chance. This research inspired me to do more of my own thinking on Nokia. I believed all phones, even low-end phones, would soon run one of the major smartphone operating systems, which would seriously harm Nokia, and I ended up profitably short-selling the stock. At the time, I incorrectly thought BlackBerry was making a comeback, so the analyst reports that convinced me to short sell Nokia saved my portfolio some damage.

Here's another example: Back in 2007, Apple introduced the very first iPhone. There was no shortage of investors and analysts who believed a $600 smartphone that was for sale at only one U.S. wireless operator, AT&T, couldn't do much damage to the major players. That's the kind of short-sighted thinking that costs most people money. But I remember reading a few different analyst reports that, collectively, convinced me to invest in the stock. The smart analysts reasoned that the price of the iPhone wouldn't stay at $600, and all major carriers would eventually carry the phone. Simply put, the product was revolutionary and, although expensive, it wasn't rational to analyze the stock based on sales over the next 12 or even 24 months.

In an example involving my own research as a former analyst, TD Securities handled the initial public offering for a small technology company in 2007. RuggedCom Inc. made highly sophisticated, shockproof IT equipment for niche buyers, such as engineers who were building networks to control the electric power grid. As with most small-cap technology companies, our client base didn't have a clear understanding of the business. Many potential investors were very fearful that the all-mighty Cisco Systems, the world leader in Internet equipment, would crush RuggedCom. I was able to spend the necessary time to call dozens of RuggedCom customers and speak to them, engineer to engineer. The insight from these calls was invaluable to help me determine that RuggedCom had a long and healthy growth curve ahead.

I should point out that in the case of RuggedCom, I published something known as an "initiation of coverage" report. When analysts launch coverage of a new stock, they do a lot of work to get up to speed on the business and form an educated opinion. When analysts do a good deal of primary research, or "digging," as we often call it, the reports are well worth reading. They often present golden nuggets that help investors form smarter opinions about the long-term direction of a business.

I absolutely reiterate my point from last week: Pay no attention to target prices and stock recommendations. But definitely do pay attention to pro-active research that gives you new information about the multiyear outlook for a business or changes the way you think about growth and its competitive challenges. Most analysts truly are smart and hard-working professionals. The design of the industry forces them to waste too much time reacting to news that is unimportant in the context of the long term. But when they have a chance to publish original thinking, it's almost always worth reading.

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