Why analyst's stock predictions are meaningless

Discussion in 'Trading' started by garfangle, Dec 21, 2010.

  1. You should not follow any recommendation made by an analyst on the future outcome of a stock's price or earnings because that is not what they get paid for or get fired over. The bulk of what a Wall Street analyst does is to research a company and provide insights as to its business and future outlook.

    However, even though they provide investors with predictions about future earnings and a price target, that is not something that you should pay attention to for one important reason: They don't get fired over wrong predictions.

    If an analyst predicts a firm will earn $1 EPS and it actual earns $1.20 does that analyst get dismissed over it? No.

    If an analyst predicts a stock will be at $50 in twelve months time and instead it hovers around $40 does he get fired by missing that number? No.

    Since all predictions are just educated opinions and every investor is provided with a disclaimer that negates any liability as to any future outcome, to trade off of what an analyst says might happen is just folly and should not be used to make an investment decision.

    N.B., Compare an analyst's opinion to a doctor's recommendation. If a doctor gives you the wrong advice and you suffer an adverse outcome, he is liable. If an analyst provides the wrong advice and you suffer an adverse outcome, he is not liable. Remember, an analyst is not your financial advisor and should not be treated as such.
  2. You are partly correct, however analyst estimates are useful for forming a rough ballpark estimate. If there are 10 analysts and all 10 are forecasting between $1 and $1.50, then you need to really have some major conviction on the microeconomic outlook of the company, or some major macro insight, to think that earnings are going to be, say, $4 per share, or a 30 cent loss. Without that conviction, you can generally assume that 1-1.50 is a semi-reasonable estimate range for the earnings.

    If you totally ignore analyst estimates, then you have to do your own forecasting of earnings - calling the company, going through widgets sold, margin estimates etc. You are then a stock analyst yourself, rather than a trader or portfolio manager. It is not possible to do that kind of detailed ground-up research AND to actively trade full-time IMO.

    So you have to look at where your edge is. Are you vastly superior at estimating earnings? Or are you superior at estimating how the market will act? If the latter, then analyst estimates are useful as part of the general market backdrop and outlook for a company. As long as you don't think they are some kind of surefire prediction with 99% accuracy, you can still use them to add valuable input as a broad estimate of earnings and trends in earnings.
  3. You can probably use it for some type of directional bias, or underlying thrust. There's always room for that type of garbage somewhere IMO :)
  4. The investor should always do his due diligence.
    Analysts do not have crystal balls, so they are not always correct.
    Analysts have to assume the auditors are doing their job, so don't blame them for Enron.
    Analysts do not control safety, so don't blame them for BP's disaster.
    etc, etc. [​IMG]
  5. 1) There can be "value" when too many analysts feel too strongly about a company's prospects from a contrary opinion perspective. :cool:
    2) Analysts are meant to be "cheerleaders" who tend to be perpetually bullish on everything in order for their company to get investment banking and advisory service business from those they analyze. :(
  6. It's useful to hear an analyst's rationale for their recommendation. Understand their assumptions. Capture their main theme and tuck it away. Compare it with other information you're hearing. This will help you make the right call down the road.
  7. What's 'due diligence' though? People always trot out this phrase, but what does it actually mean? Could you list the set of actions that make up 'due diligence', how many hours it would take an investor to do it on one stock?

    To me, due diligence is an acquirer doing literally 1000s of man hours combing through the private financials of a company, hiring professional auditors and lawyers to go through thousands of documents, double checking everything, and spending millions of dollars on it. That makes sense when you are sinking 100% of your net worth into one business, and using leverage too, so you risk bankruptcy if you are wrong. But there is no way on earth that ANY investor can do that for even the S&P 500 in a year, let alone the entire stock market.

    Also, accounting fraud only affects a small minority of stocks, and is usually detectable in an hour or two looking through the balance sheet. Fraud that cannot be detected from the accounts alone, is usually spotted by at least one professional short-seller, and then publicised widely. The number of frauds that weren't detectable from the accounts, and which no short-sellers spotted, is infinitesimally small.

    If you do a few hours research on a stock, and know how to analyze accounts, then your chance of falling victim to accounting fraud are less than your chance of dying in the next 12 months.

    By comparison, even professional corporate acquirers and control investors, like LBO firms or Warren Buffett, have been completely hosed on stock market losses from time to time. Clearly, the far greater risk when investing is *getting the business analysis wrong*, NOT missing fraud. Due diligence doesn't help one iota in analysing the business case for a company, it just tells you that the numbers are legit. But that's what auditors pretty much do already. Add in a few cursory double checks (like making sure it's a big auditor, and checking for the standard known accounting fudge techniques, huge insider sales, self-dealing, pro short-sellers screaming fraud etc) and you are pretty safe from that stuff.

    So IMO, due diligence is massively overrated. I have never done any on any stock I've ever owned, and I've never been caught in an accounting scam or fraud. Maybe it will happen one day, and I'll lose 10% overnight on one position. Well, since that can happen anyway in a random event like 9/11 or a market crash, that's par for the course. It would be literally insane for me to do professional level due diligence on every purchase (dozens per year) just to reduce the risk of losing 10% once per decade from a 1% chance to 0.1%.