The Right Way to Utilize Wall Street Research
By Robert Gordon
Twenty-First Securities Corporation
Originally published in The Philadelphia Stock Exchange, Philadelphia, Vol. 1, No. 2, July 1994.

Robert Gordon, President Twenty-First Securities Corporation

Many people are disappointed with their results after relying on Wall Street research.  We believe the "fault" lies not in the quality of the research, but in the actual implementation of the analyst's work.

Most stock analysis focuses on relative attractiveness within an industry group - i.e., the lowest-cost copper producer.  If, however, that industry suffers a setback (plunging copper prices) even the best copper stock will be dragged down with the tide.

A number of studies have indicated that these underlying forces of market and industry are responsible for up to 75% of a stock's price movement.  Utility stocks are a good example, with interest rates and the market being an inordinate influence on prices.  All the company analysis is done on a relative basis but generally implemented on an absolute basis.  Purchasing the recommendations of the best utility analyst will not ensure investment success.

Why not remove the outside influences from the recommendations entirely?  By purchasing recommended shares and simultaneously "shorting" the industry, an investor can do just that.  If the long positions are indeed better utility stocks, then the investor will prosper whether the utilities are up or down.

This shorting of an industry can be accomplished through the use of sector options traded on the Philadelphia Exchange. These indices are designed to be as representative as possible.

Given the poor recent returns of utility stocks, most investors would likely be very disappointed in the performance of any utility analyst's buy recommendations.

Utility stocks, as measured by the Philadelphia Stock Exchange Utility Sector (UTY), are down over 21 % from their September 1993 highs, and the upward trend in interest rates may lead to further erosion. In contrast, Northeast Utilities (NU), the best performer in the index, was down only 13% during the same period.  Through the purchase of Northeast Utilities and the use of sector options, it would have been possible to make money and to make the best use of analyst information.

In order to effect the above strategy, one would create a synthetic short position in the Utility Sector.  This can be accomplished through the purchase of an in-the-money put option.  With this offsetting position in place, a portfolio holding a long position in an analyst's favorite stocks would be immunized against movements in the market and changes that affect the overall industry, since they should have the same but opposite impact on the long stock and the synthetic short.  If a call is sold with the identical strike price and expiration, the cost of the put will be brought down to the point where, should there be no change in prices, the investor should earn a rate roughly equal to T-Bills because of option pricing linkages.  Only if the buy recommendation outperformed the industry would the investor earn a rate of return above the short-term risk-free rate.  Indeed, if the best utility stocks were purchased, and the market and industry effects were negated by a short position in the utility industry, an investor would have gained the approximate 8% difference in the performance of the utility index versus the best stocks and the roughly 2% in income from the option premiums collected on the short position.  The performance of the recommendation would then truly reflect the intention of the analyst, by being solely the product of stock selection.

Of course, returns will probably not match these available in a strong bull market, but we believe consistently compounded returns are more important and more rewarding over time.

Sector options, traded on the Philadelphia Stock Exchange, are a solution for investors with a desire to better utilize the research resources at their disposal.  These options are now available on a number of different industry and sector groups - utilities, banks, gold/silver, with the phone and semiconductor sectors awaiting SEC approval.  Options contracts on sectors provide a valuable tool and offer the flexibility to take advantage of investment ideas and recommendations in a logical and disciplined manner.