Analyst research is a huge waste for this one reason
‘According to a recent Thomson Reuters survey analysts historically have underestimated earnings 63 per cent of the time’
Knocking stock market analysts is a relatively harmless pastime disliked only by analysts themselves. However as these so called experts routinely misread the market and the performance of individual companies they are vulnerable to criticism of a kind that is especially justified right now as we are in the midst of the reporting season.
What usually happens is that broker’s analysts make unduly cautious estimates of corporate earnings thus allowing careless headline writers to proclaim something on the lines of “Ever Wonderful Corp results beat estimates”, however it could equally be stated that: “Ever Wonderful earnings forecasts – wrong again”.
According to a recent Thomson Reuters survey analysts historically have underestimated earnings 63 per cent of the time. This year some 78 per cent of S&P 500 companies who have reported their annual results have returned earnings above consensus estimates. In Europe analysts seem to be doing better as only 43.5 per cent of the earnings returns for the Stoxx 600 groups have beaten average estimates.
One big reason for these inaccurate estimates is that analysts are heavily dependent on corporate finance officers for the information deployed in their forecasts. Corporate executives like toying with them and can often deliberately mislead so as to lower expectations which are then confounded by “a better than expected performance”.
In Hong Kong the big tycoons do their own talking at well attended press briefings where they tend to downplay the prospects for their companies in the happy expectation that this modesty will yield plaudits for our friend - “better than expected performance”.
Willie Purves, HSBC’s first group chairman, was a master of dealing with earnings questions from analysts and journalists who huddled together for set piece occasions. He would carefully repeat whatever was asked, often slightly changing the question so that he could give the answer he preferred. In his dour Scottish way he would then insist that the bank’s prospects were confounded by an uncertain environment and therefore nothing was certain. Thus little hard information was delivered but it was withheld with style.
You don’t see much style emanating from the big locally listed mainland corporations but they are equally committed to furnishing as little information as possible. Instead they host rather selective off the record analyst briefings offering little more than tidbits that are then extrapolated into forecasts.
So analysts are left with a thin pool of data. Many of them supplement the paucity of corporate information by linking their forecasts to overall macro economic conditions – there is even a theory that illustrates this tendency, it is called the Kalecki-Levy Profit Equation. It worked quite well in reflecting stock performance during the 1929 stock market crash but has worked less well since, not least because of the proliferation of really large counters representing companies with big ideas and little in the way of actual earnings.
Ratcheting up the problem is another level of misleading equity research, which in 2003, led the US authorities to launch prosecutions against investment banks whose research material was skewed to support their other corporate interests.
Following this slew of legal action banks moved quickly to secure settlements designed to avoid putting them in the dock. Since then banks have installed higher walls separating their analysts from other parts of their business. They have also shown a tendency towards greater caution that may also explain why they are now erring on the side of underestimating earnings.
It would be foolish to assume that conflicts of interest between analysts and the companies that do business with their bosses has disappeared. These conflicts persist even when there is no smoking gun proving that lowly analyst A has been told to go easy on Company B. They do so because people working for large financial institutions are not stupid and understand what is expected of them.
Where does this leave investors? Generally speaking it means they should spend little time worrying over analyst’s estimates that are often wrong and any hapless smaller investor who thinks they will get ahead of the game by buying or selling on the basis of widely disseminated estimates will find that these forecasts have been reflected in the price well before they are able to place an order with their broker.
Indeed it is a mug’s game basing share buying and selling on projected movements in earnings. The real results, the only results that matter, will come out soon enough and there will be plenty of opportunity to judge how a company is doing and, which might be quite another matter, how it is viewed by the investment community.
Maybe however we should be going easy on stock market analysts because so many of them are being laid off at the moment. I confidently forecast that this trend will continue.