Part 3 – Lesson 6

Overview


If you listen to CNBC, you will eventually hear Wall Street professionals use the terms, “buy-side” and “sell-side.”  These terms are used to identify two major constituents in the investment community.  Buy-side refers to the community of investors including hedge funds, mutual funds, pension plans, family offices, and other institutional investors.  The sell-side refers to the community of Wall Street professionals that provide services to assist the buy-side with their investment decisions.

For example, sell-side research analysts publish research reports on public companies with Buy/Hold/Sell recommendations.  A typical sell-side research analyst will cover 10-30 public companies.  Their role is to become experts in the limited number of companies that they cover and communicate their views on these companies to their buy-side clients.  Since many buy-side analysts cover anywhere from 100 to 150 (if not more) companies, the buy-side relies heavily on sell-side analysts to provide them with in-depth research.

The sell-side firms include everyone from the large investment banks such as Goldman Sachs, Morgan Stanley, Citigroup, UBS, and Bank of America down to the boutique brokers, such as William Blair, Stifel, B Riley, and Jefferies.  At a firm such as Goldman Sachs, the bank will employ dozens of research analysts to cover a wide spectrum of public companies.  There may be one analyst covering Internet companies, one analyst covering semiconductor companies, one analyst covering healthcare companies, one analyst covering homebuilders, and so on.

The Goldman Sachs research department will circulate new research published by their analysts on a daily basis to their buy-side clients.  Buy-side investors will read the new research circulated, which can include changes in recommendation (downgrading a stock from Buy to Hold for example), changes in estimates, conversations with management, conversations with industry experts, and so on.  This information from the sell-side helps to augment buy-side analyst’s own research into the companies they are interested in.  Additionally, the buy-side clients of Goldman Sachs will meet with Goldman’s research analysts in person or by phone to discuss their views on the company and to gain a better understanding of the company.

What are consensus estimates?


One of the most important functions of the sell-side is to publish their estimates for the companies on their coverage list.  For example, the Goldman Sachs Internet analyst will publish financial forecasts (revenue, EBITDA, cash flow, etc) for the Internet companies on their coverage list and then distribute these forecasts to their clients and to various data reporting services.  One of the largest data providers in the industry is Bloomberg.  Bloomberg will then compile the estimates from all the sell-side analysts into an average number for each metric.

For example, Bloomberg will take the revenue, EBITDA, and EPS forecasts from the dozens of analysts that cover Google and present the “average” revenue, EBITDA, and EPS forecasts for 2018, 2019, and so on.  These “average” forecasts are referred to as “consensus.”  In the Bloomberg terminal, the consensus forecasts are available within the earnings estimates function.  However, due to the high cost of Bloomberg, most individual investors do not have a Bloomberg subscription.

As a general matter, “consensus” estimates are estimates that are provide by the sell-side.  You may also hear investors use the term, “buy-side consensus.”  Buy-side consensus refers to what most buy-side investors expect for a company.  Since buy-side forecasts are not published, buy-side consensus tends to be a looser definition based on having conversations with multiple buy-side investors.  Buy-side consensus is important when it is significantly different than sell-side consensus.

Why are consensus estimates so important?


Consensus estimates provides the best view on what the investment community expects a company to do in the coming years.  For example, the Goldman Sachs analyst may be too optimistic in his projections, whereas the Morgan Stanley analyst may be too pessimistic in his projections, so relying on a single bank’s estimates for a company may lead an investor to draw a conclusion that is too heavily based on one person’s view.

However, consensus estimates essentially combines the collective wisdom of all the research analysts and helps to smooth out overly bullish or bearish forecasts.  Typically, when an investor is discussing the P/E ratio or EV/EBITDA ratio, they are using a consensus estimate for EPS or EBITDA in the calculation of the valuation multiple.

For example, if Company A is trading at $15 and consensus EPS for 2019 is $0.75, then, “the market” is valuing Company A at 30x 2019 consensus EPS.

Consensus estimates are also used as the official hurdle when companies report quarterly results.  For example, many individual investors may wonder why a stock trades down when the company seemed to report strong revenue growth.  This is because a stock price’s movement depends on results vs. consensus.

For example, if consensus forecasts call for 25% revenue growth for Google for the quarter but Google ultimately reports 23% revenue growth for the quarter, then, Google stock will likely trade down because actual results were below the consensus forecast.  Even though 23% revenue growth is great, consensus estimates will need to come down due to slightly lower than expected revenue growth.

This is the holy grail of why a stock moves a certain way:

Actual results better than consensus estimates = stock goes up

Actual results worse than consensus estimates = stock goes down

This can also help you to understand why a stock goes up even when its growth is negative.  For example, if consensus estimates for Company A calls for 10% EPS decline but Company A reports a 5% EPS decline, then, the results were better than expected.  In most situations, the stock would trade up on results that were better than expected (even if those results still show negative growth).

The above formula is not fail-safe.  There are countless nuances to what drives stock movements, but more often than not, stocks go up when consensus estimates go up and stocks go down when consensus estimates go down.

Buy-side estimates vs. sell-side estimates


As mentioned above, the average sell-side estimates are referred to as “consensus.”  However, buy-side expectations are also important for a stock since buy-side estimates/expectations can often diverge from sell-side.  For example, let’s assume sell-side consensus calls for 25% revenue growth for Google.  Now, let’s assume that positive news and data points were discovered by buy-side investors intra-quarter.  If buy-side investors start to believe that the 25% revenue growth is too conservative, and Google is likely to report revenue closer to 30%, then, the bogey for the quarter then moves to 30% instead of 25%.  When Google reports results, the company must now report revenue greater than 30% for buy-side investors to be positively surprised.

Buy-side expectations that are different than sell-side usually only emerge for larger cap companies that are widely followed by buy-side investors.

Do buy-side and sell-side estimates matter if you are a long-term investor?


Yes and No.  As a long-term investor, it is important to understand the consensus expectations around future growth rates and make your own determination on how realistic those estimates are.  If the sell-side is projecting 50% growth for Google and you feel those growth rates are too optimistic, it may serve you well to avoid buying the stock until you believe consensus estimates are closer to reality.  Investing in a company where consensus estimates are too high will usually end up in a situation where the stock price follows the earnings estimates lower as actual results disappoint vs. consensus.

However, as a shareholder in a specific company, it will be your job as a long-term investor to determine when divergences from consensus estimates are material or immaterial to the long-term story.  For example, if you are invested in Company A and consensus is calling for 30% earnings growth but Company A puts up 28% earnings growth, should you sell the stock?

Although the stock will probably go down near-term due to the earnings miss, the earnings miss may be immaterial for the long-term growth outlook for the company.  Instead, if Company A reports 10% earnings growth and indicates that futures earnings growth will now be closer to 10%, this is a much bigger change in the growth outlook of the company that may warrant re-evaluating your thesis.

The “Massaging” of Sell-side Consensus


Since sell-side consensus estimates are so important in determining the near-term price direction of stocks, some corporate management teams are very sensitive to maintaining low expectations that they can beat every quarter.

Some companies try to set a low bar for the next quarter by providing conservative financial guidance to investors.  This helps to keep investor expectations low to avoid sudden downward price shocks on quarterly results.  Other companies try to manage sell-side expectations by “talking down” estimates during investor conferences when they feel like sell-side and buy-side expectations are too high.

While some investors may view this game of setting a low bar as being a cheap trick, there is a theoretical argument that good corporate communication to investors is helpful for the valuation multiple of a stock.  For example, investors feel more comfortable investing in stocks where the corporate management team has a strong history of beating their financial guidance.  Some investors may view these stocks as having less quarterly earnings risk due to the good corporate communication and may feel more comfortable paying a higher multiple for that certainty.

Conversely, stocks that regularly have large misses or beats vs. consensus will generally have larger price swings in their stock price.  Investors may view this stock volatility as adding an extra element of risk, and therefore, may ascribe a lower multiple to earnings that appear to have more volatility.