At the start of each year, I write about how useless forecasts by strategists and analysts are. One thing that is persistent in these forecasts is that fair value estimates by equity analysts tend to be overly optimistic while forecasts from strategists tend to be too pessimistic. But why are the target prices of analysts for stocks they cover on average too high?
I was a sell side analyst for 16 years, and there are massive institutionalized psychological and job preservation reasons for what you've observed. You say "[t]his is why I always recommend investors take a close look at the growth rates analysts price into their models for the next three to five years. This is where they fudge their models to fit the present, and where they become overly optimistic to justify overvalued markets." I couldn't agree more, but even healthy scepticism shouldn't always drive one to simply haircut the assumptions ... sometimes they're actually way too conservative.
Walk into your morning meeting as an analyst and present a buy recommendation with a price target 50-60% higher, and your salespeople will tell you "that's ridiculous", my clients will laugh you out of the room". Cook up a target 5-10% higher, and they'll say "my clients won't even cross the street for that ... and if you really feel that way, then why isn't it a "hold" or a "sell"? I've never seen any academic work on it, but I'd bet the median street analyst target price upside is +20-30%, because that's the range everyone seems to feel is "reasonble" and/or "attractive", and not "ludicrous".
Even though 95% of all ratings are "buy" or "hold", and 60% of that 95% are "buys", no one ever seems to notice that having over half the market mis-priced to the tune of 25% doesn't exactly jibe with the efficient markets hypothesis. It's like Lake Wobegon, "where all the women are strong, all the men are good-looking, and all the children are above average" https://en.wikipedia.org/wiki/Lake_Wobegon . Also, on the banking prospect side of things, sitting with your firm's investment bankers at a company pitch and telling management that you're valuing their stock using a GDP-minus 2% terminal growth rate is definitely not career enhancing.
I think the bigger issue is that there are too many examples where slavish devotion to terminal value DCF modeling has kept people away from some seriously great 20-year stocks: Apple Computer stock has compounded up 30% per year (!) from $1.25 to $247 over two decades; modeling modest assumptions about growth reversions in mobile 'phones wouldn't have gotten you anywhere. Amazon.com stock went from $2.21 to $213, +26% per annum. Even the stock of Microsoft, now an almost half-century-old company, went from $26 to $398, +15% per annum over that 20-year timeframe. Now, with that perfect knowledge, climb into your time machine, go back to 2005, and write three research reports using 30%, 26%, or even a 15% terminal growth rate assumptions in your DCF modeling to produce +19,660%, +9,538%, and +1,431% price targets, respecively, and see how long until you'd've lost your job and been hauled off to the loony bin.
Then there are stocks that used to be called "concept stocks" that are all over the place, seemingly driven solely by animal spirits. A car company should be pretty simple to value, but Tesla stock was $250 last Halloween, $450 right before Christmas, and is back to $300 today. Palantir stock is down 30% in the past week, but even after that it's trading for 70x sales and 450x earnings. Any attempts to slap a DCF on those would clearly not assume reversion to a 2% growth rate.
(1) “Sell side” reports by analysts are over optimistic - possible conflict of interest with a company for which the analyst’s employer does other work.
(2) It is not easy to identify future Revenues and Earnings.
(3) ‘Discount Rate’ is a crude measure.
(4) Much better would be a report on ‘Fundamentals’ and - in the context of the chosen company - whether it is likely to grow; taking account on Macro features for that individual company.
(5) Only after reviewing fundamentals, can the potential share price be stated (as a range of probabilities) .
Oh analysis reports from the sell side are worth reading but you have to know what to look for. Mostly look for the stuff they don’t write that you would expect in a positive report. That’s the stuff you need to pay attention to.
most of my success in investing has been holding on to sensible american GARP fund managers. they have underperformed megacap indexes, but have been disciplined for exiting meme multiples which seems to have been a credible risk lowering tactic.
i do not discount the role of luck for them , as they still need a few % differentiated weight profile to win. remarkably, they have all lost money flows and re-opened to new investors. some managers have not embraced an active ETF structure.
as a few times in the past, i wonder if this is the end for active growth success.
I was a sell side analyst for 16 years, and there are massive institutionalized psychological and job preservation reasons for what you've observed. You say "[t]his is why I always recommend investors take a close look at the growth rates analysts price into their models for the next three to five years. This is where they fudge their models to fit the present, and where they become overly optimistic to justify overvalued markets." I couldn't agree more, but even healthy scepticism shouldn't always drive one to simply haircut the assumptions ... sometimes they're actually way too conservative.
Walk into your morning meeting as an analyst and present a buy recommendation with a price target 50-60% higher, and your salespeople will tell you "that's ridiculous", my clients will laugh you out of the room". Cook up a target 5-10% higher, and they'll say "my clients won't even cross the street for that ... and if you really feel that way, then why isn't it a "hold" or a "sell"? I've never seen any academic work on it, but I'd bet the median street analyst target price upside is +20-30%, because that's the range everyone seems to feel is "reasonble" and/or "attractive", and not "ludicrous".
Even though 95% of all ratings are "buy" or "hold", and 60% of that 95% are "buys", no one ever seems to notice that having over half the market mis-priced to the tune of 25% doesn't exactly jibe with the efficient markets hypothesis. It's like Lake Wobegon, "where all the women are strong, all the men are good-looking, and all the children are above average" https://en.wikipedia.org/wiki/Lake_Wobegon . Also, on the banking prospect side of things, sitting with your firm's investment bankers at a company pitch and telling management that you're valuing their stock using a GDP-minus 2% terminal growth rate is definitely not career enhancing.
I think the bigger issue is that there are too many examples where slavish devotion to terminal value DCF modeling has kept people away from some seriously great 20-year stocks: Apple Computer stock has compounded up 30% per year (!) from $1.25 to $247 over two decades; modeling modest assumptions about growth reversions in mobile 'phones wouldn't have gotten you anywhere. Amazon.com stock went from $2.21 to $213, +26% per annum. Even the stock of Microsoft, now an almost half-century-old company, went from $26 to $398, +15% per annum over that 20-year timeframe. Now, with that perfect knowledge, climb into your time machine, go back to 2005, and write three research reports using 30%, 26%, or even a 15% terminal growth rate assumptions in your DCF modeling to produce +19,660%, +9,538%, and +1,431% price targets, respecively, and see how long until you'd've lost your job and been hauled off to the loony bin.
Then there are stocks that used to be called "concept stocks" that are all over the place, seemingly driven solely by animal spirits. A car company should be pretty simple to value, but Tesla stock was $250 last Halloween, $450 right before Christmas, and is back to $300 today. Palantir stock is down 30% in the past week, but even after that it's trading for 70x sales and 450x earnings. Any attempts to slap a DCF on those would clearly not assume reversion to a 2% growth rate.
In fact, the whole Magnificent Seven appears to be an "exception that proves the rule" exercise https://en.wikipedia.org/wiki/Exception_that_proves_the_rule ... let's just hope it's not another Nifty Fifty https://en.wikipedia.org/wiki/Nifty_Fifty .
Is any stock analysis report worth looking at?
(1) “Sell side” reports by analysts are over optimistic - possible conflict of interest with a company for which the analyst’s employer does other work.
(2) It is not easy to identify future Revenues and Earnings.
(3) ‘Discount Rate’ is a crude measure.
(4) Much better would be a report on ‘Fundamentals’ and - in the context of the chosen company - whether it is likely to grow; taking account on Macro features for that individual company.
(5) Only after reviewing fundamentals, can the potential share price be stated (as a range of probabilities) .
Gunnar M will know more.
Oh analysis reports from the sell side are worth reading but you have to know what to look for. Mostly look for the stuff they don’t write that you would expect in a positive report. That’s the stuff you need to pay attention to.
survivorship bias speaking here:
most of my success in investing has been holding on to sensible american GARP fund managers. they have underperformed megacap indexes, but have been disciplined for exiting meme multiples which seems to have been a credible risk lowering tactic.
i do not discount the role of luck for them , as they still need a few % differentiated weight profile to win. remarkably, they have all lost money flows and re-opened to new investors. some managers have not embraced an active ETF structure.
as a few times in the past, i wonder if this is the end for active growth success.