Managing a portfolio
It is so much harder to let go of those beliefs, facts be damned
In heaven, investors might dream of buying stocks low and selling high. That’s actually what we try to do here on earth but it’s really tough. In this post I propose to explore a few ideas around the problem investors face in relying on analysts’ opinions that are out-of-consensus.
By definition, most analysts’ opinions are close to consensus. Prices in the stock market tend to track consensus. To either buy low or sell high the investor can sometimes rely on an analyst’s opinion that is out-of-consensus, that places the fair value of a stock at some distance from its current price.
It’s often called being contrarian.
Market vagaries
In The Intelligent Investor, Benjamin Graham has a section titled ‘Purchase of Bargain Issues’ (Graham, 1973) p82 He introduces his discussion of taking advantage of the vagaries of the market by saying:
“The market is fond of making mountains out of molehills and exaggerating ordinary vicissitudes into major setbacks. Even a mere lack of interest or enthusiasm may impel a price decline to absurdly low levels. Thus, we have what appear to be two major sources of undervaluation: (1) currently disappointing results and (2) protracted neglect or unpopularity.
The way of pricing
In a following chapter titled ‘The investor and Market Fluctuations’, Graham writes:
“Since common stocks, even of investment grade, are subject to recurrent and wide fluctuations in their prices, the intelligent investor should be interested in the possibilities of profiting from these pendulum swings. There are two possible ways by which he may try to do this: the way of timing and the way of pricing. By timing we mean the endeavor to anticipate the action of the stock market – to buy or hold when the future course is deemed to be upward, to sell or refrain from buying when the course is downward. By pricing we mean the endeavor to buy stocks when they are quoted below their fair value and to sell them when they rise above such value.” (Graham, 1973) p95 (Emphasis added)
This quote makes clear that the way of pricing is not the practice of market timing. Graham goes on to develop his thesis of the way of pricing and ultimately calls it buying with a Margin of Safety.
Graham defines a bargain as a stock which ‘on the basis of analysis’ is worth considerably more than the price it is selling for.
Analysis using discounted cash flow
The proper way to analyze the fair value of a stock is the use of discounted cash flows (DCF). The analyst predicts the expected cash flows a company will produce a few years into the future and then discounts those cash flows back to the present to arrive at a fair value today. Readers not familiar with DCF analysis might read this post – The dangers and benefits of using Discounted Cash Flow analysis reports
Out-of-consensus
As an investor I am always on the lookout for analysts’ reports that suggest a stock is worth considerably more than the price it is selling for. These are analysts’ opinions that are out-of-consensus. These are potential buys.
For any stocks I own, I monitor closely the DCF opinions of value for any changes in the analyst’s opinion. Here I am monitoring for downgrading of fair value or upgrading of fair value. If there is a significant downgrading of a stock’s fair value this might be a signal to sell. If there is a significant upgrading of fair value this might be a signal to buy more.
If the analyst’s opinion of fair value stays the same but the stock price has run up to wildly overpriced, this might be a time to sell.
Here’s the problem
Once an analyst has offered an opinion about the fair value of a stock, the analyst has a vested interest in the opinion. And here I’m focused on out-of-consensus opinions.
Imagine an analyst using DCF produces an estimate of fair value that is 30% higher than the current market price. An investor buying at the current price would hope that over time the price would find its way to fair value. Let’s say a year goes by and the price is still substantially depressed below the fair value estimate. And then another year goes by and the price is still depressed, and so on. And yet the DCF analyst still pegs the fair value way above the current price. The question, at that point, becomes whether the market is simply slow to recognize the value in the company or whether the analyst was too optimistic in their estimate of fair value. If the analyst hasn’t changed their estimate of fair value, is it because the shares truly are worth a lot more than the current market price? Or is it because the analyst is reluctant to change their opinion for fear of looking bad or admitting they were wrong.
Let me offer a short quote from Annie Duke’s book Quit – The Power of Knowing When to Walk Away published in 2022.
“…we need to be particularly cautious when a belief is outside the mainstream and public because it is so much harder to let go of those beliefs, facts be damned.” (Duke, 2022) p175
Duke cites a study carried out by Kary Milkman, a professor at the Wharton School and John Beshears of the Harvard Business School and published in 2011 titled: Do Sell-Side stock Analysts Exhibit Escalation of Commitment. The study looked at what happened to analysts who made earnings estimates that were way out-of-consensus when those estimates later turned out to be far off actual earnings. The question was whether the analysts would stubbornly stick to their original forecasts, or would they revise the projections based on the new information? (Duke, 2022) p173
It seems the further the analysts’ opinions were away from consensus, the more they stuck stubbornly to their estimates by updating even when their estimates were far off actual reported earnings. It seems that the further you are outside the mainstream the harder it is to let go of mistaken beliefs.
The danger of being a contrarian
This underscores one danger of relying on out-of-consensus fair value estimates. If a considerable time goes by, if the analyst is sticking by their high fair value estimate and the stock price is still stuck in the basement, there may come a time to sell.
The danger of relying on an out-of-consensus analysis is not far off from the danger of investors own confirmation bias and sunk cost fallacy. We buy a stock thinking we are smart. We tend to see only evidence that confirms our prior belief and confirms how smart we are. We have a lot of time invested in the stock, so we tend to want to stick with it.
When to bail out
Philip Fisher who was a great influence on Warren Buffett wrote in 1979:
“If I have a deep conviction about a stock that has not performed by the end of three years, I will sell it. If this same stock had performed worse rather than better than the market for a year of two, I won’t like it. However, assuming that nothing has happened to change my original view of the company, I will continue to hold it for three years.” (Fisher, Common Stocks and Uncommon Profits and Other Writings. 1958,1996) p244
Joel Greenblatt notes that he tells his MBA students that Mr. Market will eventually agree with their valuation. He writes: “I tell them that, though it can occasionally take longer, if their analysis is correct, two to three years is usually all the time they’ll have to wait for Mr. Market to reward their bargain purchases with a fair price.” (Greenblatt, The Little Book That Beats the Market. 2006) p96
Templeton says: “Benjamin Graham did feel that if he bought a stock, thinking it was the best bargain, and in two or three years it hadn’t proved to be a good bargain, then he should change. Too much changing is too expensive. And so, at present I’m holding things longer than four or five years. But the time period isn’t really the thing that guides me in making my decisions. (Proctor & Phillips, The Templeton Touch, 1983, 2012) p109
Whether it’s three years or four or five, it’s only a rule of thumb. No rule is ever hard and fast. But, calling it a rule is useful because of the Sunk Cost Fallacy. We will tend to hang on the stock of a company that we’ve put so many of our hopes into, not to speak of hard-earned cash. The problem is, of course, we hope the price will move up and justify the cost and effort we have put into it.
When one buys an unloved stock at a bargain price, one has to be prepared for a fair bit of time to go by before your wallflower becomes the belle of the ball. This is where patience is important. In the meantime, you may have to suffer through many disparaging comments about the company and the sideways glances of acquaintances who know you hold the stock. In these situations, it is a mistake to sell too early.
Conclusion
Buying stocks in superb companies that are bargain priced because of currently disappointing results, protracted neglect or unpopularity can produce superior returns over time. Investors rely on analysts’ reports but have to be careful when the opinions of fair value are quite a bit different from market prices. There are opportunities but there are also dangers. Be aware that out-of-consensus analysts may become wedded to a wrong opinion.
+++++++++++++++
Readers wishing to dig deeper into the use of analysts’ reports may wish to check out these posts.
How to buy stocks at bargain prices
How to get the most out of analysts’ reports
Analysts’ reports and the estimate revision game
The problem with analysts’ target prices
+++++++++++++++
You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
+++++++++++++++
Want to dig deeper into the principles behind successful investing? Click on the ABOUT tab to read an introduction. It will help readers get the most out of the Nuggets of Investing Wisdom blog.
+++++++++++++++
Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
+++++++++++++++
You can also use the word search feature on the right-hand side of this page to find references in both Nuggets blog posts and also in the Motherlode.
+++++++++++++++
To explore the Motherlode, click on the Motherlode tab
If you like this blog, tell your friends about it
And don’t hesitate to provide comments or share on Twitter and Facebook