Star analysts think they know better

Personally, I am not a fan of the habit of company management providing guidance for sales or earnings. That is, quite frankly, the job of analysts and by providing guidance, corporate executives try to influence analyst forecasts in a certain direction and in make analyst forecasts less informative for investors (at least in my view) because forecasts bunch up around management guidance.

The counterargument to my view is that company management typically knows better than analysts how the company is going to perform in the future. Thus, management should be able to make better forecasts about sales or earnings than analysts.

And that counterargument is true as a study from the University of New South Wales shows. The study looked at the earnings forecasts of individual analysts in the US and how these forecasts compare to company guidance. Crucially, the study differentiated between ‘reputable’ analysts that have been selected in the Institutional Investor All-American analyst team and the many others covering the same company. In practice, it is really hard to assess the skill of an analyst so many investors rely on things like the All-American analyst survey or the Extel survey in Europe to decide, where to allocate their research money and which analysts to follow.

That study found two important things. First, star analysts rely less on management forecasts than the average analyst. In particular, if company management provides positive guidance, star analysts are more likely to issue forecasts that are below management guidance. Second, it looked at the accuracy of the forecasts and found that analysts who relied less on management guidance saw their forecast accuracy decline. Turns out management guidance really is on average a better forecast than what analysts produce.

Lesson number from this study is thus that investors should ignore analyst rankings like the All-American research team. The forecasts of these star analysts are typically no better and sometimes worse than the forecasts of the average analyst.

But there is a second lesson that is more worrisome. The study found that while star analyst forecast accuracy declined if they relied less on company guidance, their impact on the market increased. If a star analyst makes a forecast that differs more from company guidance, share prices react 21% more strongly than if a regular analyst makes such forecasts. The authors of the study claim that this is because star analyst forecasts sacrifice accuracy for bringing out new information that the market wasn’t aware of. And I will call bs on that interpretation.

In my experience, star analysts deviate more from management guidance because it makes them stand out from the crowd. And the share price reacts more strongly to these forecasts because they are covered more broadly in the media and followed by more investors. It is the fame of these star analysts that makes the market move not the ‘informativeness’ of their forecasts. The price investors pay for following these star analysts is that they are faced with less accurate forecasts and thus are likely to make worse investment decisions. Star analysts think they know better, and investors are worse off if they believe them.

In practice, this study shows that investors are typically better off ignoring these rankings like the Excel survey or the All-American ranking and instead looking at the track record of previous analyst forecasts. And when I mean the previous forecasts, I mean ALL previous forecasts. So many analysts and economists dine out for years on the one right call they made in 2008 and never mention the dozens of terrible calls they made since. And this then leads to headlines like this one…