Analysts’ reports and the estimate revision game

Finding and studying companies

Target Prices are based on overoptimistic estimates

Sell side analysts are an optimistic bunch. In fact they are too optimistic, especially with their earnings estimates. Investors relying blindly on these estimates are in for trouble.

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, Irrational Exuberence, 2005 Second Edition)p.45. (Emphasis added)

But, there’s a paradox. Even with overly optimistic earnings estimates companies regularly ‘beat’ the estimates. What gives?

Sell side analysts

There are two kinds of analysts: the first are so called ‘sell-side’ analysts, the second are the independents. Investors typically have access to sell side analysts’ reports through their broker, whether discount or full service.

The sell side of the investment industry is the investment banks, commercial banks and stock brokerage firms. The sell side are often financial conglomerates that include corporate finance and advisory services that help companies raise money by selling shares to the public. They also offer brokerage services to investors. Therein lies the potential for conflicts of interest.

Incidentally, 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’ reports are basically a marketing tool for other arms of the financial conglomerate to use. The research arm of these organizations is a cost center and not a profit center. It is at the beck and call of the profit center arms.

Consider the position of the lowly analyst who must opine on the future prospects of a corporation that does business with another arm of the finance conglomerate. Or the finance conglomerate may simply wish to do business with the public company. They will be loath to point out negatives about the company. At best, they might fall back on the old saying: if you can’t say something nice about someone, don’t say anything. At worst the report may be hopelessly compromised and distorted.

One doesn’t have to be much of a cynic to realize that an analyst preparing a report on the investment merits of a public company that another arm of the financial conglomerate does, or wishes to do, corporate finance work for is in an impossible conflict situation. Chinese walls are tissue thin.

The world of corporate finance and public companies is a very small one. Sell side analysts overwhelmingly issue ‘outperform’ and ‘top pick’ reports on public companies. The ‘underperform’ and ‘sell recommendation’ reports are in a miniscule minority

The earnings estimate 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 in the sell side analysts’ reports tend to be based on the estimates for the next full fiscal year.

Because Target Prices from sell side analysts are based on overoptimistic estimates of future earnings, the Target Prices are over optimistic.

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. At the same time, the Target Prices may not be lowered to more realistic levels.

I’m not making this up. It has been studied by Ed Yardini. Look at the following two graphs which chart earnings estimates. They show the tendency to overestimate in most markets. The exception is at market lows when the analysts underestimate earnings.

Earnings Estimates. 1995-2017

Earnings Estimates. 1975-1995

What to do about it?

For the most part the factual and even opinion information in the reports is extremely useful for investors, if you take the estimates with a grain of salt. The discussion of Target Price impediments is particularly useful. Target Price impediments are the risks, such as new product introduction problems, problems in the economy, and so on.

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.

Since sell side analysts’ 12 month Target Prices are almost always 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 reports very occasionally 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.

Conclusion

In spite of all I have written above, once you realize their limitations, the sell side research reports are generally of fairly high quality and of real use.

Readers wishing to dig deeper into the subject of building and managing a portfolio can look at Chapter 40. Finding and Studying Companies to Invest in

That chapter contains these Section:

40.01 News media

40.02 Positive media stories generally indicate the end of superior performance

40.03 Analysts’ reports and other sources

40.04 Methodical approach

40.05 Analysts’ reports more

40.06 The earnings estimate game

40.07 Herding and the short term

40.08 Reading deeper in sell side analysts’ reports

40.09 An aside about facts vs opinions

40.10 Analysts’ reports continued

40.11 Conclusions re sell side analysts’ reports