Keep your wits about you
Analysts’ reports will be available through your discount broker. Since analysts’ reports are so important in our work of identifying and studying companies to invest in, we need to look at the strengths and weaknesses of these reports.
There are two kinds of analysts: the first are so called ‘sell-side’ analysts, the second are the independents. In this note I want to focus on the sell-side.
In spite of the criticisms I offer below, once you realize their limitations, the sell side research reports are generally of fairly high quality. For the investor the challenge is not the quality of the research. It is what is done with the research. The individual investor really has access to just as good quality research as most professional money managers. One has to make good use of it.
Sell side reports
The sell side of the investment industry is the investment banks, commercial banks and stock brokerage firms that offer services including advice to investors. The buy side of the industry includes retail investors, institutional investors, hedge funds, money managers, asset managers and so on. The buy side typically are clients of the sell side. The sell side makes money by selling products and services to the buy side.
The sell-side analysts work for brokerage houses. The sell-side analysts’ reports are basically a marketing tool. The reports are highly structured, usually short and easily read. They tread a fine line between being highly conventional and somewhat differentiated for marketing purposes.
The reports typically contain five elements: (1) news such as quarterly earnings or corporate developments; (2) news analysis, as in, what does this news mean for the company? (3) earnings’ and other financial estimates such as cash flows or balances sheet figures; (4) frequently, an investment thesis, and, (4) Price Targets and basis for same.
Let’s take a look at several aspects of sell-side analysts’ reports. There are several problems.
Not estimate of fair value
They do not (with some very limited exceptions) purport to assess the fair value of the companies.
The reports offer a Target Price. The targets are typically prices the analyst expects the shares to trade at in the next twelve months. The reports explain how those targets are arrived at. Usually it is a multiple of some sort such as price to estimated earnings (Forward P/E) or enterprise value to earnings before interest and taxes (EV/EBIT) or enterprise value to earnings before interest, taxes, depreciation and amortization (EV/EBITDA) or price cash flow (P/CF) or very occasionally even a discounted cash flow analysis.
So what’s a target? No analyst is capable of predicting the price a stock will reach in the next twelve months. They will say: ‘It’s simply a target’. They offer it simply as a price the stock might reach based on their ‘analysis’.
It’s important for investors to realize it is not an estimate of fair value.
Biased to the upside
It has been estimated by Bloomberg that some 60 to 65% of analysts’ reports are effectively buy recommendations, 35% effectively hold recommendations and less than 5% are sell recommendations. Each analysts has their own way of expressing this. The categories might be ‘top pick’, ‘outperform’, ‘market perform’ and ‘underperform’, or some such.
The fact is, sell side analysts are congenitally optimistic.
In looking at the precipitating factors that led to the dot com stock bubble, Shiller considers the contribution by analysts’ optimistic forecasts. He reports that: “According to a study by Steven Sharpe of the Federal Reserve Board, analysts’ expectations of growth in the S&P 500 earnings per share exceeded actual growth in nineteen of the twenty-one years between 1979 and 1999. The average difference between the projected and actual growth rate of earnings was 9 percentage points. The analysts breezed through both the steep recession of 1980-81 and the recession of 1990-91, making forecasts of earnings growth in the 10% range.” (Shiller, 2005 Second Edition)p.45.
As Peter Lynch points out: “Just when the analysts predict double-digit growth rates forever, the industry goes into decline.” (Lynch, 1989,1990)p.142.
Since sell side analysts’ 12 month Target Prices are usually much higher that the fair value estimates produced by independent analysts using discounted cash flow methods, I track them on charts for the companies in my portfolio. A large discrepancy is noteworthy.
The earnings game
There is a game played by sell side analysts and companies. It is probably human nature combined with the culture of the sell side of the investment industry.
Analysts are looking about eighteen months ahead. As one fiscal year progresses, naturally they have to look at the next fiscal year. Target Prices tend to be based on the estimates for the next full fiscal year.
Target Prices from sell side analysts are based on overoptimistic estimates of future earnings by the sell side analysts.
In light of this it is, at first blush, totally surprising that some 68% of companies beat analysts’ estimates of quarterly earnings when earnings are announced each quarter. What gives?
The explanation is that a company beating its earnings estimates is a happy event for company management. Company executives are aware of the optimistic over estimates that have been published. They don’t mind them at the time as the optimistic estimates help their share price.
As the quarter progresses, especially on the earnings call with analysts on the publication of the previous month’s earnings, management guide the analysts’ estimates lower to a point where the company should be able to beat the now lowered estimates easily. In other words, the earnings estimates are part of an elaborate game. To read more deeply about the estimate revision game and check out some statistics see my post here.
Getting the most out of them
With these caveats, we must acknowledge the reports contain valuable information.
Sell side analysts’ reports typically contain one or two years of historical financial data and estimates of future numbers. These might include earnings per share, price earnings ratios on both historical and estimated earnings, cash flow numbers both historic and estimated future, price to cash flow ratios, book values per share both historic and estimated, figures for enterprise value (EV) and EV/EBITDA ratios both historic and estimated, dividends per share and yield calculations.
The reports also typically include balance sheet and cash flow detail over the historic and forecast period and other useful ratios for the same periods such as EBITDA to interest expense ratio, debt equity ratio, net debt to EBITDA ratio, current ratio, ROA, ROE, dividend payout ratio and so on.
They also contain a company description, statement of investment rationale, explanation of how the Target Price is arrived at and a discussion of the impediments that might stand in the way of the price target being reached, that is, all the things that might go wrong.
This is very useful.
The reports sometimes contain negative opinions about a company. These are particularly useful. The opinions contained in the sell side analysts’ reports typically reflect the ‘street’ or investment community’s view of companies being covered. A feeling for what the street thinks can be usefully for a discerning investor. Of course, market prices often reflect the ‘street’ opinion of value. But, why a stock is priced the way it is, is useful.
For the intelligent investor, it is often the ability to discern the difference between the ‘street’ view and intrinsic value that discloses real investment opportunities.
To learn more about building a portfolio of stocks take a look at Chapter 40. Finding and studying companies to invest in
To read more deeply about the intelligent use of analysts’ reports, take a look at the following:
Section 40.05 Analysts’ reports more
Section 40.06 The earnings estimate game
Section 40.07 Herding and the short term
To read up on understanding and using Discounted Cash Flow based analysts’ reports see Chapter 38. The Problem of Determining Intrinsic Value
And specifically Section 38.01 Analysts’ reports
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