The future is never clear
I regularly read analysts’ reports. I find a lot of useful information in them. I take the target prices with a big grain of salt.
One thing that gets my attention is when the analysts say they like the company but recommend holding off investing because of a ‘lack of visibility’ in future earnings.
I’ve seen this expression ‘lack of visibility’ dozens of times over the years. They also have other ways of expressing it, but ‘lack of visibility’ is quite common. I guess it’s the lingo of the trade.
What I do know is that when I read this or similar comments in an analyst’s report I think this may the signal for a great buying opportunity, that is, to buy at a very attractive price. It may reflect the street consensus.
A word about sell side analysts’ reports
We know that analysts come up with target prices. These are not estimates of fair value. They are more aspirational. No one can say a target was wrong. It was, after all, just a target. An estimate of fair value is a more serious proposition.
The target prices are based on ratios, like price to earnings or enterprise value to EBITDA. Analysts are in the business of coming up with earnings estimates. See my post below for the games they play. The thing to note for present purposes is that the earnings estimate is central to how they come up with the target price.
So, if it’s very hard to come up with a good earnings estimate, it’s very hard to come up with a target price. If there is a ‘lack of visibility’ in future earnings, they are in a bind.
I’ve never worked in the investment industry but I suspect it would be career limiting for an analyst to project earnings without good visibility. Career pressures can cause analysts to be risk averse. As a result, in situations where there is change within a company, the analyst may be unwilling to look beyond the next quarter or even that far.
Loving lack of visibility
But, uncertainty or ‘lack of visibility’ is actually the investor’s friend. Consider the following from Warren Buffett. In 1979 he wrote an essay for Forbes magazine in which he said: “The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.” (Lowenstein, Buffett, The Making of an American Capitalist, 1995,2008) p.233.
John Templeton is quoted in The Templeton Touch: “The great majority of people are looking at the short range – what’s going to have higher earnings next month or next year. But we focus on what a company could earn two years or five years from now. One of the reasons our performance is said to be the best investment record in the world on a twenty- to twenty-five-year basis is that we’ve always tried to look ahead – and the long-range view requires patience.” (Proctor & Phillips, The Templeton Touch, 1983, 2012)p.299.
Illustrating the problem
Let’s say a company decides to embark of a major facility expansion program. It is currently the low cost producer in its industry. This status has allowed it to generate excess capital. Many analysts and shareholders have been expecting the company use these funds to increase its dividend. The company’s directors have substantial holdings of common shares and think long term. They decide the company cannot rest on its laurels. It must continue to invest to stay ahead of the competition. The company announces a major facility expansion project. Benefits from the capital project, in terms of increased sales and profits, will not be seen for at least eighteen months.
The market reacts badly. Analysts say that there will be no ‘visibility’ on increased earnings for many quarters and worry that the increased earnings may never materialize in this competitive industry. A substantial gap opens between price and intrinsic value. The gap is not caused by inefficiency of the market in processing the information. It occurs because the street seems congenitally programed to short term thinking, that is, Mr. Market frames narrowly and seems incapable of framing broadly.
Things are never clear
Peter Lynch tells us: “It’s also important to be able to make decisions without complete or perfect information. Things are almost never clear on Wall Street, or when they are, then it’s too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.” (Lynch, One Up on Wall Street, 1989,1990)p.69.
George Soros explains the problem. “It is difficult to accept uncertainty. It is tempting to try and escape it by kidding ourselves and each other, but that is liable to land us in greater difficulties.” (Soros, The Crash of 2008 and What it Means, 2008,2009) P230
A few examples
Without trying to be comprehensive, here are a few examples of what can cause a ‘lack of visibility’ and uncertainty over the next few quarters, or year or even longer:
- Management is investing in the business for the long term and sacrificing short term profits
- There have been recent weak earnings or sales that are probably temporary
- Management in a growing company is guiding for lower near term future sales and/or profits
- Because of economic conditions there is poor visibility of future sales and earnings increases
- Management is planning a large acquisition
- There is uncertainty regarding succession planning
The solution to the problem is quite straightforward. Warren Buffett reminds us that we are investing in businesses not in stocks. The difference is profound. You cannot invest in a company unless you understand the business. That’s why we invest in companies within our circle of competence. A business is not just a bundle of data largely derived from financial statements. How you go about analysing a business and assessing it value is part of your investment process. It’s what Ben Graham calls your ‘principles of operation’. When you understand the business you can have more confidence about what is over the horizon.
The concept of sound investing Principles of Operation are introduced in the Motherlode in Part 4: Principles of Operation. The essential principles are describes briefly in Chapter 27. Sound Principles of Operation. There you will find cross references to the main text of the Motherlode where each of the Principles of Operation are discussed in full. They include things like buying with a Margin of Safety.
To dig deeper into the issue of stock market uncertainty check out these blog posts:
Let’s cut to the heart of how risk and uncertainty impact diversification
Many investors just don’t understand the risk/reward trade-off
Do quants with algorithms have an advantage over other investors?
The conventional view of market efficiency is badly mistaken
To read more about issues surrounding the use of analysts’ reports take a look at these blog posts
Analysts’ reports and the estimate revision game
The problem with analysts’ target prices
How to get the most out of analysts’ reports
You can reach me by email at firstname.lastname@example.org
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