Picking Fights With Sell-Side Research Returns
The Dumpster Dive Continues
Part 1 (Read Here)
As you may recall, I’ve got a gnarly penchant for bad sell-side research. A couple weeks ago I initiated coverage on some of Bay Street’s most notorious bucket shops / boiler rooms. Well, I’m still in the trenches. With the amount of froth that’s arisen in the markets over these last few weeks, I think now is an excellent time to shine the spotlight on a few “special” firms. The crème de la crème de la back alleys, if you will. Since all of these shops are independents, however, I should probably give you some historical context before proceeding further. Patience, subs. There’s an art to this business that warrants a certain level of respect and appreciation. I promise your due diligence will be rewarded. So, put on your buckets — the dumpster dive continues.
A little history lesson: way back in the day, the independent dealer model was highly lucrative if you were nimble and creative with your trading; the big banks were fat cats that were too slow to innovate and had grown complacent with their monopoly on stock underwriting (not much has changed on that front). If you were willing to thwart convention and play in the obscurer parts of the market, you could make a serious killing. Among these types of firms were the legendary likes of Gordon Capital, Wood Gundy, McLeod Young Weir, Dominion Securities, A.E. Ames, First Marathon, and GMP Securities.
Gordon Capital infamously made its way into legitimacy by outright inventing the bought deal. First Marathon rose quickly through the ranks by pioneering the discount brokerage model. GMP Securities, with its employee-owned focus and “eat what you kill” approach to business, opened its doors in 1995 and rocked the street. Though GMP has always had a penchant for mining, they’ve helped finance some of Canada’s (former) golden boys, like Blackberry and Birchcliff Energy.
Things slowly started to change at the turn of the new century, however, as trading fees began to compress and the big banks started gobbling up these independents in an effort to protect and expand their market share. Today, most of the few that remain have been reduced to shadows of their former selves and the independent model appears to be stuck at its worst. If it’s any indication, just look at GMP Securities’ stock price over the last 10 years and Eight Capital’s recent influx of departure announcements. Yikes.
So what’s in it for today’s independents? In order to answer that question, you need to understand the core economics of the independent brokerage model. Some of you may be familiar with this stuff, and I will admittedly be oversimplifying here. But just in case, let’s make sure we’re all on the same page. Capiche?
Broadly speaking, here are the key ingredients you need to make an independent broker: 1) an investment banking division, 2) a sales & trading desk, 3) research coverage, and most importantly 4) a retail distribution arm. Quantities may vary.
The first three points are pretty intuitive. These are the integral components to any capital markets operation, but the fourth one is especially important because if you’re bottom feeding deals you need to be able to tap into a pool of willing retail participants. And if you’re not at the top of the league table, you’re going to be bottom feeding. Unfortunately, many of Canada’s independents aren’t even ranked on the top 10.
Bottom feeding is the independent brokerage way of today.
So, as it stands for research, all you have to do then is slap your firm’s name on a report, a couple MBA/CFA/PhD designations, and the due diligence is done. All a retail distributor/advisor has to do is hit the bid on those buy recommendations. Right? Of course not, although it would appear that this happens more often than not. It doesn’t take a CFA to figure out that you should always do your own due dil and form your own opinion (and no, reading more than one research report from multiple sources is not complete due diligence, you’re still in the bush leagues at that point).
Still, there’s got to be some legitimacy to these reports if they’re still widely circulated and in demand, right? Well, instead of throwing conjectures, let’s actually take a look to find out for ourselves; an objective assessment of the quality of research coming out of a few of these firms will prove beneficial. This is where things get gnarly.
A simple, yet effective way to assess a firm’s research aptitude is by analyzing the return distribution on their buy recommendations. These numbers don’t lie. Luckily for you, I’ve done some of the work so that you don’t have to. The following are return distributions over the last 5 years for a couple notable firms. Spoiler alert: these figures ain’t pretty, reader beware.
Let’s start with small- to mid-cap bookrunner and TSX Venture connoisseur, Mackie Research Capital Corp. Mackie’s one of Bay Street’s oldest firms. They’ve got a nickname on the street that goes before Mackie that I won’t repeat here, but it rhymes with flashy. Mackie banks smaller companies, mostly for equity financings and private placements. They’ve got 8 research analysts covering ~70 names. As you would expect, there’s lots of energy, mining, cannabis, and healthcare names in the mix. How’ve their recommendations held up?
Mackie Research Corp. – Return Distribution Since Initiating
It’s bad. You’re looking at a decidedly negatively-skewed return distribution and a 1/3 positive hit rate here – the rest have been sent into P&L hell. I’m no national math contest winner, but those are some pretty awful odds. I’ll give them some credit: it’s not all that bad. They’ve got some notably outsized wins on the cannabis and mining side. However, this doesn’t nearly make up for the fact that for every right call they make, 2 are wrong. Almost all of their bad calls relate to overhyped cannabis, healthcare, and energy stocks. For an institution that has “Research” in their actual name, you’d think their performance would be a tad better. Perhaps they should do some research on this issue.
PI Financial is the next shop on our list, and for good reason. In case you missed it, the former head and prolific acquirer of PI Financial, Gary Ng, is facing allegations of fraud by IIROC. OPM Wars covered the story first, which you can read here. PI Financial is a Vancouver-based investment dealer with a penchant for junior miner deals. The firm’s been around the block for a while now, since 1982. Mr. Ng always bragged about the quality of the firm’s services when speaking about his newly acquired broker. However, it’s well-documented that they’re a bit of a bucket shop. Plus, they’re based out of BC, a province that has introduced a well-documented list of frauds, money laundering operations, and illegitimacy to Canadian capital markets. In any case, will the numbers tell us differently?
PI Financial – Return Distribution Since Initiating
Nope, they don’t tell us differently. A little better than Mackie mind you, but returns are still negatively skewed; you’re looking at a ~½ success rate here. Fun fact, that’s actually in line with what most value investors will tell you a good hit rate should look like. Still, losing 50% of the time is a tough business. Luckily for these analysts, they don’t always have to put their money where their mouth is. PI’s made a bunch of good mining calls, which is where the bulk of their winnings come from. That at the least is worth something. On the other hand, a lot of their cannabis and tech calls have tanked. No surprises here, since they were at the forefront of the cannabis bubble. They even took the infamous Green Organic Dutchman (TGOD) public with Canaccord, an offering that didn’t work out too well in the end, as the stock’s down -92% from its IPO price.
The last firm we’ll be covering today is Haywood Securities. They too have been around for a while, since 1981. There was some reputational clout behind them back in the day, as they were able to poach a notable handful of advisors from First Marathon in 1999. These days, you’ll find them financing a slew of small mining companies and a couple speculative telehealth / healthcare / cannabis names (by now you should have started to pick up on a trend). So, has Haywood weathered out better than their peers and have their recommendations done any better?
Haywood Securities – Return Distribution Since Initiating
Not really. A less than ½ success rate and a still decidedly negative skew. It seems that this is the industry benchmark. Doesn’t make it easier to stomach those odds, though. Like most other shops, their wins are mostly attributable to their mining picks. Any recommendation outside of that sector, however, gets funky really quickly. Haywood’s losses stem primarily from energy, consumers, and tech stocks. If there’s one thing Haywood appears to be reasonably good at, it’s hitting the buy button on hype at the top.
Here’s what we learned today: today’s independents are (most of the time) great at picking mining stocks. Bay Street runs on mining. Clearly, however, running a practice Stratton-Oakmont style doesn’t necessarily lead to great recommendations for retail investors, rather lucrative banking fees. This is an oft-forgotten reality, and it doesn’t take intense data mining to figure that one out. Names like FIRE, LABS, HEXO, WTER, and NDVA were once all the hype on the street. Hype, however, is ephemeral (obviously, that’s what makes it hype) and is always followed by sudden fades.
The sobering truth of all of this is that this behaviour — performance chasing, FOMO, stock promotion, speculative booms & busts — is a natural facet of markets and the industry. Someone has to bank these speculative companies and someone has to sit on the other end of that trade to create demand. Nothing innately wrong with that — got to keep the pipes flowing somehow.
When times are good, who really cares? No one, apparently, until things inflect. There’s a reason why there are always more buy recommendations than sells out there. Do people get it right? Of course they do, it’s their bloody damn job. Do people get it wrong? By the looks of it, more often than not. With less than a ~½ chance of being right behind your back, you should obviously be thinking for yourself.
Combined Returns Plot
Perhaps I am a cynic. Perhaps I am being too harsh. But put it this way. How much capital would you be willing to wager on what is, at the end of the day, a crappy coin toss?
Speculatively,
G.G.
Not investment advice.