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“COMPANY MISSES ESTIMATE, STOCK DOWN!” The Risk of Research failure

Equity research reports which are available in the public domain and those consumed by the majority, are largely authored by analysts who are positioned on the sell side. We conducted a study recently to understand the quality of such sell side research’s. The data involved collecting the consensus estimates provided by some of the top sell side research houses over the last 6 years (for 24 quarters). The future earnings estimates over which the fair values are calculated kept changing each quarter. The current year profits were estimated two years in advance and the variance from the first estimate to the actual reported number was atleast 30-40% away in most cases. As the estimates are revised each quarter, so was the Target price. It was also noted that at most times target prices were aggressive during bull markets and subdued during bear markets (a fallout of confirmation bias). While we can attribute the revision of the estimates/target prices due to changing scenarios, the question arises- What happens to the lay investor who purchased the stock two years ago based on the initial estimates. Is there any relevance if estimates are going to change anyway. What is the basis of the target price and the extent of ambiguity it entails. In most cases, popular media places the blame on the Company that announced results for not matching the Analyst’s expectations, while logically it should be the other way round… (the headline generally goes “COMPANY MISSES ESTIMATE, STOCK DOWN!!”).

A sell side analyst is incentivised based on the number of reports published and companies that are covered. Sell side players benefit from the volume of trades and are paid through the brokerage earned by the entity. Here lies a fundamental principal-agent problem arising from conflict of interests. Hence there is a good chance that the advice that you receive from a Brokerage firm will have more quantity than quality. The continuous flurry of information aim to confuse rather than enlighten the investor, forcing multiple unnecessary trades, thereby making the broker the sole beneficiary of the transaction.

Interpreting the stock markets became a full-fledged job only about 40-50 years ago and since then this conflict has remained. While there have been attempts to resolve it, hardly has there been a solution yet. The introduction of “Markets in Financial Instruments Directive” as early as 2004 to focus on shortfalls in the structural integrity of equity research markets was the best attempt taken thus far in this direction. The European Commission introduced the 2nd version on January 3, 2017. The legislation focuses on improving transparency, enabling clients to understand how their money is being used, ensuring that reports do not directly induce investment in the underlying stock and ultimately providing unbiased research to investors. By unbundling transaction costs and cost of research, MiFID-2 is expected to significantly reduce overheads and allow entities to quantify exactly their expense on research. Although the jurisdiction of this new legislation will include only European countries; it is expected to have widespread effects on the structure of financial institutions and how they interact with their research providers globally. As of now only a handful of independent research entities provide quality unbiased opinions. Earlier, nobody was willing to pay for such services hence none of them survived. There is now a growing patronage for such independent unbiased opinions from both the retail as well as institutions. No wonder equity research budgets of brokerage houses are shrinking each year, a clear indication of their declining relevance.

In the past, equity researchers added value by providing additional information that may not have reached everyone. This role is also becoming redundant with the advent of technology, internet and developments in the data service providers who are closing the information asymmetry.

Equity Research in its current form was propagated by Irving Fisher followed by Benjamin Graham in the 1930s. Later it was eulogised by Buffet and since then we have continued to follow pretty much the same methods of valuation. While technology has only improved the way trades are executed and availability of data, it has been incapable of changing the process of valuation. There is significant ambiguity involved while preparing financial models- assumptions taken, methods used, margin of error considered and target prices arrived; hence the result of the research remains suspect. Majority of the estimates are prepared based on the historical financial statements, company filings, management interactions without further scrutiny of the actual ground reality. The analysis of financial’ s becomes a farce when the statements itself is fudged as witnessed in cases like Satyam and others. We have also witnessed instances of auditors suddenly resigning and suspecting the very own books that they had audited until recently! Finally, the investor needs to understand that the Intrinsic value is an overused imaginary number that doesn’t have a scientific backing, it varies from analyst to analyst. None of the hundred tools/methods available are fool proof and there is a good Risk of Research failure. While this Risk is clear, it is seldom an acknowledged fact.
Two things are of immediate priority; a need for restructuring of the incentives of the researcher and improvements from the archaic methods of analysis/concept of target prices. Stay away from the media noise that hype research houses, which communicate in gullible jargons. The guy onscreen doesn’t have a crystal ball (if he did he wouldn’t be onscreen!). The onus is now on the investor to choose from the variety of research sources and arrive at an informed decision.
I asked a friend of mine who is the Chef de partie of a busy restaurant, about the warning sign in front of his kitchen which read “Do Not Enter Without Permission”. He simply replied “The process in which the food reaches your plate is not the most exciting one”. Hmmm…I replied, “and don’t ever peep into an analyst’s excel its worse!” and in our case we have replaced the warning sign, with a “Disclaimer”!