Hard as it may sometimes be to comprehend, one thing remains certain: analysts are human. They are not the calmly scientific investigators many in the IR community perceive them to be. Nor are they automatons solely dedicated to producing research notes. Professional, yes. Well, most of them, anyway. Infallible, no. Completely impartial, no.
Analysts are just as susceptible to hype and inflated expectations as the rest of us. Add in the possible conflicts of interest in today’s integrated banking world and you have a recipe for disastrous forecasting. Yesterday’s buoyant expectations are soon replaced by today’s reality.
One example from recent slip-ups demonstrates the argument. Telephone data provider Phonelink was floated in March last year, issuing 8.3 mn shares at 180p. Chief executive Trevor Burke said its Tel-Me information system had reached ‘an exciting stage of development’, a claim enthusiastically endorsed by house broker SBC Warburg.
But, contrary to the optimistic forecasts, losses continued to pile up and the shares had fallen to 68p by the end of the year. Soon after floating, in a move that apparently wrong-footed the analysts, the company shifted strategy to concentrate on business users rather than private individuals. The shares have picked up slightly and are hovering around the 80p mark, having been as high as 205p and as low as 43p in their short public life, but an awful lot of money got burned in the initial hype fire.
Overly Optimistic
Recent research points out that analysts have a dismal record in forecasting earnings growth and are systematically over-optimistic about companies’ prospects.
Professor George Bulkley and Dr Richard Harris of the University of Exeter’s in the UK, looked at analysts’ forecasts of earnings growth over a five-year period and found that there was virtually no correlation between forecast growth and actual growth. In Bulkley and Harris’ judgment, professional analysts are remarkably bad at forecasting and a better assessment could be made by ignoring the analysts altogether. They go so far as to suggest it may be just as reliable to assume a company’s earnings will grow at the same rate as those of the average company.
‘Analysts may have an incentive to produce extreme forecasts in order to generate trades upon which they earn commission, and a rational market would therefore discount their forecasts,’ say Bulkley and Harris. Examining share price evidence, however, they found that ‘stock returns are positively correlated with analysts’ forecast errors over the same period, which implies that their forecasts are indeed reflected in prices’.
Harris says that there is an explanation for the analysts’ mediocre track record, other than the unkind one that analysts do not know what they’re talking about. ‘If you want to sell shares, or maintain good relations with the companies you analyze, it is rational to be over-optimistic.’ A leading regional stockbroker gives another, equally valid, reason: ‘If you see a rapidly expanding company and fancy getting your foot in the door, then you’ll issue flattering reports and forecasts.’
Alan Sugar, chairman of electronics group Amstrad, takes a less charitable view and refers to ‘the gentlemen of the City, who have difficulty identifying a snowflake in a snowstorm’. Sugar has had his own battles with the analyst community and takes some pleasure in saying that they have a habit of falling victim to their own hype.
The extent to which analysts are pursuing hidden agendas and perhaps serving their own ends has already given rise to serious concern in the United States. Europe looks set to emulate this concern. And, while this practice is disturbing in developed, regulated and relatively well-researched markets, it becomes alarming for those investing in emerging markets, where there are far fewer analysts competing to release accurate research.
Open Book
There is a growing feeling among European investors and fund managers that analysts should be required to nail their colours to the mast much more firmly and by being compelled to state their interests in a stock.
Investors with good eyesight will come across the small-printed provisos at the end of a report: ‘We or a connected person may have positions in or options on the securities mentioned or may buy, sell or offer to make a purchase or sale of such securities’ runs a typical health warning. But for the most part, the loudly trumpeted recommendation to buy and the rose-tinted view of the company’s future prospects will overshadow any hint of caution.
Several of the casualties with badly burnt fingers and lightened pockets say that all provisos and warning clauses should be up front, in clear type, and given equal prominence to the analyst’s recommendation. Further, they say that any connection whatsoever with a stock should be quantified or described in sufficient detail to allow investors to make an informed and realistic judgment.
There is much talk of the so-called ‘Chinese walls’ within securities houses, with each department resolutely and steadfastly tending its own affairs and making sure that its own interests do not overtly influence or subvert those of any other department. In practice, of course, this is almost impossible to achieve. As one observer puts it: ‘Chinese walls are a Chinese illusion.’
Corporate pressure to support client companies or those with shares in abundant supply within a trading division will be very hard to resist, particularly when research analysts’ pay and bonuses depend on the overall success of their employers.
Analysts are generally believed to have a good working relationship with the companies in which they specialize, and it is easy to allow that assumption to color the interpretation of their forecasts and predictions. After all, they know what they’re talking about, don’t they?
One senior London broker, who prefers not to be named, describes this optimistic view as ‘rubbish’ and says that you might just as well stick pins in a sheet of paper. ‘What happens is that the analyst looks at last year’s earnings and adds on a bit for growth and perhaps another bit for a new product or a hot area like biotechnology or digital broadcasting. Then he takes away a bit, to be cautious. The skill, if there is any, is in working out what size the bits should be. He only knows what the company wants him to know and what he’s picked up from looking at the industry as an outsider. It’s nothing more than informed guesswork, and analysts often get it wrong.’
Trend Indicators
Not everyone is quite so critical of the analyst community. The European fund manager of a leading Irish institution says that analysts’ reports are useful in terms of industry background, trends and indicators. ‘We rely on them for their knowledge of the company and for a flow of information. Then we put whatever slant we choose on their conclusions. It’s not particularly helpful to enter into a debate about how accurately they predict EPS or profit numbers.’
This latter point is reinforced by Peter Knapton, managing director of Legal & General Investment Management. ‘Forecasting is a difficult skill, and it is not surprising that analysts don’t get point forecasts exactly right. We find analysts’ reports very useful and the investment community is pretty well-served by its analysts. They provide us with reasonably full background information about a company and its strategy and understand its strengths.’ In Knapton’s view, analysts don’t survive unless they’re good at what they do – and he thinks analysts in the UK are among the best around.
By and large, continental European analysts have a much harder time getting at the facts behind individual companies. As Knapton sees it, the raw material is not as readily available. ‘Companies are less forthright and reporting requirements are different, so we shouldn’t expect the same standards of analysis as in the UK and the US.’ However, he believes that the situation is improving and that many European analysts are now producing reports of a very high standard.
Jean-Francois Carminati, corporate IR officer at Elf Aquitaine and a former analyst, agrees that analysts are getting better at fundamental research, but he believes that ‘commercial considerations’ are affecting the ways in which reports are written and presented. And he thinks it happens a lot.
‘Analysts are honest,’ he says, ‘but there are pressures from the corporate finance and brokerage parts of their firms. The game is the same for everyone in the firm.’
He draws attention to the spate of favorable reports on any privatization candidate, particularly where brokers may be competing for work in the IPO. ‘Direct pressure is not put on the analyst, but it is mentioned that a good and positive report would help the firm get the work.’
Carminati says that French companies in particular are now devoting more effort to their relationships with continental European analysts. ‘For some time, French analysts felt that preference was being given to UK and American specialists, but now Elf and other companies are concentrating more on the domestic French market.’
He believes that analysts are very important to both the companies they cover and the fund managers which invest in those companies. ‘But fund managers are becoming more and more skeptical about analysts’ reports,’ he says. ‘And they are questioning their opinions more closely. Fund managers are developing better direct connections with the companies and are only taking notice of two or three proven analysts.’
Legal & General and its fellow internationally-focused institutions have the capability to go anywhere in the world for analysis and research and are in an enviable position to weigh up a wide selection of reports and recommendations. Equally, some larger funds tend to steer clear of higher-risk stocks that may lend themselves to barnstorming and hype. Most long-term fund managers have the experience and the street sense not to be taken in by over-enthusiastic appraisals. Knapton says that ‘all reports have a message in them and it is our job to understand that message for what it is’.
Smaller Concerns
It follows then that the smaller institutions and investors are most at risk when analysts get carried away with stocks in which they have an interest. Companies that appear particularly prone to analyst hype are those where the founding entrepreneurs take huge receipts from the flotation and then head off into the wide blue yonder, leaving numbed investors to pick up the pieces when the hoped-for profits do not materialize.
Typical of these surprise packages is cable and satellite TV decoder manufacturer Pace Micro Technology, where the two founders, David Hood and Barry Rubery, collected nearly £180 mn between them in June last year. The company came to the market amid high expectations and the IPO placed the shares at 172p each. The company is now down in the dumps, with the shares struggling to break back through the 100p barrier, having been as low as 80p.
In between, Pace shares reached as high as 242.5p, helped by enthusiastic earnings forecasts by house broker Panmure Gordon. Pre-tax profits for 1995-96 were reported at £18.2 mn (up from £3.4 mn in 1994-95), and Panmure Gordon confidently forecast 1996-97 profits of £26.1 mn – a rise of 43 percent, mostly fueled by overseas earnings. When the shares were at 224p in December last year, Panmure Gordon came out with a buy recommendation, saying that profits were expected to double by May 1998 with EPS rising from 6.1p to 11p in the same period.
Within five weeks of that optimistic forecast, the company issued a warning that overseas contracts were not expected to generate the increased sales signaled by Panmure Gordon and the market slashed 25 percent off the share price. Just three weeks later, another profits warning caused an even stronger reaction, forcing the shares down by 45 percent to 86p and wiping out in one day all the gains made since flotation. At one time in its brief life, Pace had a market worth of £427 mn; it is now valued at less than half that.
Hard-hit institutional investors have demanded changes in the management structure at Pace, and are critical of the two founders for selling so much stock in the IPO. But all that was apparent at the time of the flotation. Investors must bear a lot of the blame for swallowing all the marketing hype. Ruefully counting his losses, one fund manager says: ‘Pace has always promised a lot. We would like to see it start to deliver.’
Game On
Another in this unwelcome roll of honour is Limelight, a home improvements group, which floated last October, producing ú60 mn for its founder Stephen Boler. He kept a 17 percent stake, but gave up active involvement and went off to Africa to start a game reserve.
The prospectus forecast ú15.8 mn profits for 1996 and the shares were placed at 175p. Cazenove talked the shares up and investors piled in, pushing the shares to a high of 200p.
Half a year later, Limelight investors are looking at huge losses. Five months after its launch, Limelight issued a profits warning – saying first quarter sales in its principal business were down by 32 percent. The shares plummeted by 45 percent and kept on going down. One fund manager says: ‘We knew the business could be volatile but we did not expect a trading statement like that.’ The shares are currently floundering around the 80p mark, having been down to 78p, and are proving hard to shift. Sadly, investors chose not to follow strong advice like that given by the Investors Chronicle: ‘Ignore.’
The point about Pace, Limelight and others in the same mould is not that business conditions became tough; that’s par for the course. What is disturbing is that analysts hyped the issues enthusiastically and kept the balloons flying until they were brought down by hard facts.
Even then, there often appears a reluctance to admit that the vessel has sprung a leak. At the beginning of March, one of the longest quoted companies on the London Stock Exchange, leisure equipment and center operator Hawtin, held an upbeat and enthusiastic AGM, with the company’s directors promising great things for the future.
Less than 24 hours later, an early morning announcement revealed that reorganization costs in the US would have a substantial impact on first-half profits. Hawtin’s managing director says that it wasn’t until after the AGM that house brokers Kleinwort Benson had advised him to make the announcement. Gavin Budd, of joint brokers Brewin Dolphin Bell Lawrie, comments: ‘This was something of a surprise, a shock even, following hard on the heels of the AGM.’ Not surprisingly, the market took exception to the sudden profits warning and the shares fell by 13 percent.
The market may well take greater exception at similar shocks in the future. If the sell-side does not clean up its act then the trend towards greater buy-side research can only continue to grow. Either that or regulators will step in to enforce greater discipline upon the analyst profession. And you can rest assured that is something sell-side analysts will not be recommending.
