A discussion about analysts and recommendations

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Someone sent me a question privately which I answered, but I thought that the exchange would be better on the board so everyone can benefit from it. It deals with the question of how analyst and MF recommendations can go so wrong, and how to discover it before it’s too late. Here it goes::

10/24/14

Hi Saul, You had reported that you had much success with the stock market. You also were kind enough to share your secret sauce. It was probably the best post I have read so far, and even tops Tom Engle’s long posts.

I compiled a table that I am attaching. It shows you the stock price projections for some stocks that interest me from a year ago, and then prices of those same stocks today.

*prices as of yesterday
For e.g.
WPRT: analysts projected 32 but it is currently at 5.92.
AMBA: analysts projected 20.25, but it is currently at 40.50
GOOLG, PCLN and BOFI on the other hand are currently trading at very close to what the analysts projected a year ago.

Remember, the analyst projections are a consensus figure, not of any single analyst. So a year ago, there could be a lone analyst who projected WPRT to go down from where it was. It was at 24. Deutche Bank had $35 PT and Goldman had $21. There is an analyst Rupert Merer with $16 PT. His current PT is $5. DB reduced it to $12. You get the picture.

My question to you is, it is evident from the table that even Wall St analysts can’t get it right. And these are the people who read and attend the conference calls, and investor conferences, talk to the management, assess the competition and basically live and breathe the company. If the people who are spending their full time on this get it wrong, how can we get it right? How can we still manage to beat the market and if we happen to do, how can you not conclude that it must be fluke. You are a medical doctor. When you take actions as a doctor, I am sure you are lot more certain then when you or for that matter anyone including an investment professional can ever be when they take actions on their investments.

Any thoughts to share or advice for me?

XXX

(A table followed here of XXX’s stocks, with stocks going from WPRT, SODA and XONE which had dropped 82%, 74% and 70% in the past year, to AMBA, which was up 100%. I couldn’t figure out how to put a table in my post, but it’s not necessary.)

10/24

Hi XXX, I’m glad to respond, but I think this belongs on the board instead of as a personal communication as it is applicable for everyone. But here goes:

Analysts don’t mean anything. They have to follow 100’s of stocks, so they can’t know much about any of them. If their company is doing financing for the company, with the big commissions that that involves, or hope to run financing for the company, they can’t predict negatively. Often they forget to bring a recommendation up to date for 6 months or a year or more., etc.

with regards to the stocks on your list, starting at the top.

WPRT - 2 yrs ago, when they were at $29.50 I pointed out that they had $30 million in revenue for the quarter and $36 million in losses, and a gross margin of about 25%, so they would have had to quintuple their revenue to just hope to break even, not even make a profit. An insane investment, but one that was pushed hard by MF. (At under $6, who knows, it could take off and triple, or go to zero).

SODA - I had invested in them but it became very, very, clear that things were not right, long before it nose-dived. I got out.

XONE - Like WPRT, a perpetual money loser. When it and Arcam were both around $55 but Arcam was making money, I suggested a switch to Arcam. Now XONE is at $20 and Arcam is at $26…after a 4 for 1 split!!!

LULU - I had been in them too but got out because of the enormous PE, and problems starting in growth.

DDD - I got out because of enormous PE, because they wouldn’t answer conf call questions about whether they had any organic growth or whether it was all acquisitions, and because founder sold 50% of his position suddenly.

MTZ - I liked the company, but got out when they had flat earnings for three quarters in a row, and said they were having trouble with their largest customer. What more do you need?
etc

In other words, a lot of this is common sense. You can do better than analysts. Most of them don’t do so well at all. Pay attention to severe warning signs. Don’t buy story stocks that are losing lots of money, but hope to break even the year after next (which often gets pushed off indefinitely).

I hope this helps. If you want to post your question on the board, I’ll post and expand my answer.

Saul

Thanks Saul. I appreciate your responses. I suppose it’s easy for you because you tend to make the correct decision based on information presented to you. I heard about your pessimissm on WPRT and the amount of criticism you got, evne though you were 110% right. I sold partial position in MTZ but honestly I had no idea they are having trouble. I sold because I found the valuation rich.

I wasn’t sure how to attach that picture. And I wanted to hear your views specifically, that’s why asked you directly. If you wish to post this on the board, feel free to post the numbers from the attached table.

Just one more note. The reason I am so confused that analysts failed to do their job is, I know that analysts usually cover only a handfun of stocks in their industry. This number could be large for e.g 10 but it’s not going to be 20, 50 or 100 stocks. For e.g. for RBC, Mark Mahaney covers PCLN and he covers 25 other stocks with a small team of analysts working for him. Josh Olson of Edward Jones covers only 14 stocks including PCLN. So I would have expected them to do better.
XXX

10/24/14
“I sold partial position in MTZ but honestly I had no idea they are having trouble.”

XXX, This is from the last MTZ quarterly report :

"Second quarter 2014 continuing operations adjusted diluted earnings per share, a non-GAAP measure, was $0.40, compared to $0.47 last year.

Second quarter 2014 continuing operations adjusted EBITDA, also a non-GAAP measure, was $106 million compared to $110 million in 2013.

“We had a challenging second quarter, primarily because of slowdown in revenue growth of wireless projects. Our guidance for the second half of 2014 reflects reduced levels of expected wireless project revenue, when compared to prior year, and we have taken and will continue to take steps to mitigate the impact of these reduced revenue levels. We anticipate a return to a more normalized level of wireless project revenue in 2015.”

As I remember this was the third quarter of disappointing results and disappointing forecasts. Did I want to stay in this stock? …No. Nothing complicated. Just seemed like common sense that I had better places to put my money. I’m not a genius, really.

Saul

10/25
Hey Saul,

Thanks again. Just trying to understand your process more.

Management said things will normalize next year. What was the reason you didn’t give that statement much credit?

Second, they mentioned they have won some broadband gigabit project worth quarter of a billion. Isn’t that good?

Finally, how do you decide when to give management credit. I know you were long elli and my guess is you trust the management when they say their product can generate so much extra revenue per mortgage. I have no way of knowing whether that’s true or false. It’s probably true. I sold only because of large stock grants. I don’t know whether it’s the right decision. But there are so many stocks. So I decided to stay away since I am not comfortable. I think eventually elli gets acquired.

Regarding SODA, it took the stock to drop from 75 to around 45 before I realized things are not going well. CEO claimed he can see 1 billion revenue by 2016. Today it’s clear they will struggle to touch 600 million unless the Pepsi partnership pays off. I started reading reports about slowing flavor sales. First management sugar coated this by suggesting things like channel inventory or something like sell in or sell through. Point is they gave an excuse which I foolishly believed. But eventually it became clear they were actually lying. Correct? How would I know truth from lies? Or do you prefer to trust reported numbers and ignore managements excuses?

Same with WPRT. Except I caught the CEO sooner. I sold in 2012 for 45 and I believe that was at a loss. I saw an interview of the CEO and I could not really develop any trust in him. It seemed like he was trying to make things up. Of course I was in no way certain. I could have been way wrong. Their numbers were bad too. That probably was another reason I sold. But I am going to study and find out what went so horribly wrong.

Thanks, XXX

At this point I really felt I had to insist that this should continue on the board and wrote:

XXX, Would you mind if I posted our exchange on the board so everyone can benefit from it? I can keep you anonymous if you prefer.
Saul

XXX responded :

Sounds good. Yes anonymous. I might join though with questions.

Thank you.

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MTZManagement said things will normalize next year. What was the reason you didn’t give that statement much credit?

Well, that’s not actually what they said. What they did way was “We anticipate a return to a “more normalized” level of wireless project revenue in 2015.” …And what does “normalized” mean anyway? That’s not like saying “We anticipate a return to rapid growth”.

I started reading reports about slowing SODA flavor sales. First management sugar coated this

This was key. If you are buying something because of a razor/razorblade model, and they aren’t selling razorblades, something isn’t working. Buying razors and putting them in the closet isn’t what you want.

Same with WPRT. Except I caught the CEO sooner. I sold in 2012 for 45

Great sale, you got about the all-time high!

Saul

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My question to you is, it is evident from the table that even Wall St analysts can’t get it right. And these are the people who read and attend the conference calls, and investor conferences, talk to the management, assess the competition and basically live and breathe the company. If the people who are spending their full time on this get it wrong, how can we get it right?

Because Wall St. analysts aren’t trying to get it right, they’re trying to keep their jobs. If you’re right when everyone else is wrong, you might get a little pat on the back – maybe – but if you’re wrong when everyone else is right you get fired. So the prudent thing is to always run with the herd. It doesn’t matter if you’re wrong as long as everyone else is wrong too. That’s also one of the reasons you’ll frequently see analysts follow the market, downgrading stocks after they drop and upgrading them after they rise.

The Economist has run a few articles about how inaccurate professional analysts are. Here’s the money quote from one about how retail investors are much better at predicting macro moves than professionals:

One investment strategist once told your correspondent, “It makes no sense for me to predict a recession. If I’m right, no one will thank me and if I’m wrong, I will get fired.”

Interestingly, studies also show that analyst estimates and advice gets even worse when the market turns down, when big banks tend to cut budgets. Maybe that’s because those cuts reduce the amount of research analysts can do, but frankly I imagine career risk is also at the forefront of everyone’s minds during times of severe cuts and scarce hiring.

Studies have also shown that analysts who think the most of themselves and tend to garner the most media attention have poorer track records. Yet another reason to ignore financial media.

Even if you’re dealing with an analyst who tries their best, their analysis isn’t intended for long-term retail investors like us, but for hedge funds and mutual funds that are trading in and out of stocks. That means they’re myopically focused on the next quarter or two, often at the expense of the much bigger picture that might be unfolding (good or bad).

I also think that many analysts are tripped up by false precision in their models. In an effort to give very accurate forecasts, they end up making a lot of assumptions, each one of which has some error in it. Those errors all add up until the forecast as a whole has a large margin of error, but all you ever see at the end is a precise target price.

I think successful retail investors, on the other hand, tend to be looking at a few big things that are driving the company over the next few years and are more concerned that they’re on the right track rather than trying to estimate precise values for next quarter. We win by changing the rules and not playing Wall St. at their own game.

Interestingly, if you read The Outsiders by William Thorndike about some of the greatest CEOs over the past 50 years (and by great, the book means CEOs that generated enormous market-thumping wealth for their shareholders), there’s an obvious trend that they too look at only a few key things when considering acquisitions and are able to make very quick and successful long-term decisions. Warren Buffet said “I am a better investor because I am a businessman and a better businessman because I am an investor” and I think that reveals a big part of the simple secret to being a successful investor: begin thinking like a CEO and evaluating your investments based on the quality of the business rather than a handful of short-term financial or economic metrics. What are the most critical things that are likely to drive the business to success over the next 3-5 years and beyond, and do those look like they’re on the right track? You’ll never be right 100% of the time, but I suspect you’ll be better off than you would be listening to the EPS estimates of Wall Street analysts for next quarter. And over time, as you gain more experience, your ability to judge the quality of a business and its management will improve.

Anyway, here are a few articles about poor analyst performance from The Economist. Peter Lynch also talks about it some in his book One Up on Wall Street. And The Outsiders is a great read if you haven’t read it yet.

http://www.economist.com/news/finance-and-economics/21604190…

http://www.economist.com/news/finance-and-economics/21594358…

http://www.economist.com/news/21589145-how-sort-best-rest-wh…

Neil

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Great discussion, Neil. I almost never see a regular analyst make a call before a down move on any stock. At $40 it’s a “strong buy”. At $35 it’s a “strong buy”. At $30 it’s a “strong buy”. At $25 it’s a “strong buy”.

Then, after being wrong all the way down, when it gets to $20, and when maybe it has actually become a buy, they drop their call and say it’s a “Hold”. What kind of help for the investor is that?

Because Wall St. analysts aren’t trying to get it right, they’re trying to keep their jobs. If you’re right when everyone else is wrong, you might get a little pat on the back – maybe – but if you’re wrong when everyone else is right you get fired. So the prudent thing is to always run with the herd. It doesn’t matter if you’re wrong as long as everyone else is wrong too.

Peter Lynch said the same thing about mutual fund managers in one of his books. Something like “No one ever got fired for buying IBM” (It was an earlier era). “If it goes down the boss will just say ‘IBM didn’t do too well this quarter. Tough luck’. But if you buy a risky stock that none ever heard of and it does poorly, you may lose your job.”

Saul

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I have been very busy running for re-election so I have not been posting much but I want to chime in here.

I think the biggest advantage we have a individual investors is we can ignore any stock as too hard to know. Take Coke for example, will they ever grow again, or have consumers turned away permanently from sugar water? Every Wall Street shop has an analyst covering Coke, they have to have an opinion. Me, not so much. I really do not have any idea if they can grow again. Or they are in a long decline as people decide to focus on health.

I used to have about half of my portfolio in BRK, but I sold it when Buffett refused to sell KO at some sky high PE, I don’t remember how much it was something silly like a 45 PE. I bought BRK when the dot coms were going bananas and BRK was unloved. But it no longer made sense. I loved my BRK and would tell my kids all the time oh you are part owner in See’s candy and Benjamin Moore paint… BRK might have been able to find growth again but for me it was too hard to call it was so big that I thought it would mean revert. Time to move on.

I love CMG as a company but at a 65 PE I still hold but I will not buy any more. Too hard to call, I hope it gets down to a 30 PE because I think they will grow and add formats, but at 65 PE it is too hard to call. But the big firms all have a position.

It is ok to go to what you are most confident in, and ignore the rest.

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I have been very busy running for re-election so I have not been posting much but I want to chime in here.

Okay, Flygal, I can’t resist asking: Re-election for what???

Saul

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I am on my local school board.

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I am on my local school board.

Hi Flygal, congratulations on winning the election.
Saul