FYI | Apr 02 2009
By Greg Peel
The following question has been posed by an FNArena subscriber which is so fundamental to the very nature of stock markets – or any market for that matter – and one which we do get asked rather frequently, that we decided it was time to provide a public response.
“G’day Rudi and team. I have a question that is puzzling me very much. I get a lot out of FNArena, but what’s got me puzzled is some of the stock analysis. All the brokers are looking at the same numbers and information but their calls some times are totally opposite. Can you enlighten me on why this happens or suggest some reading material I can source to help me? Regards Mike”
G’day Mike
Yours is a question we are often asked in one sense or another. Sometimes the question comes in the form of “Why should I subscribe to a service that tells me that one broker says Buy and another says Sell? How does that help the inexperienced investor?”. However framed, it is a very reasonable question.
Let’s start by imagining the opposite situation.
Let’s assume that presented with “the same numbers and information” all stock analysts must, by definition, arrive at the same conclusion. That conclusion might be that “stock XYZ is trading at $1.00 today but we calculate its real value to be $1.50 so we’re recommending a Buy”. Now assume that those in the stock market are separated simply into “stock analysts”, being anyone who has the experience and tools to arrive at a $1.50 valuation, be they specifically an analyst employed by a broker, or a fund manager, or even a private investor, and “investors”, being the group of people without the necessary experience and valuation tools who rely on advice from the experts in making investment decisions.
What we would have is a situation where everybody would want to buy XYZ either because they arrived at the same valuation or their broker told them to buy, and no one would want to sell XYZ, even if they already owned some, until it reached $1.50. In such a situation the share price of XYZ would go straight to $1.50 and stay there, at least until there were some new numbers or information to absorb.
For every listed stock there would simply be an immediate adjustment in price, staccato fashion, because everything that can be known is. An investor could never actually make any money, because no one would be prepared to sell at anything less the universally agreed value, and no one would be prepared to buy at any more.
In short, there would be no market.
Now take this assumption right to the source. Why does a company raise capital by offering shares to the public in the first place? Usually because it needs the money to carry out the business it has planned and doesn’t have enough money of its own. Now – stock analysts will put a value on a stock right from its initial public offering (IPO). They all have “the same numbers and information” at the beginning (bearing mind public listing requires full disclosure of all information) so should thus all be able to say, given our assumption, that this stock will be worth $1.50 in a year’s time (where one year’s time is arbitrary – what about two year’s time, five year’s time?).
Stock analysts not only advise investors, they advise companies as to what price they should offer their stock at. If everyone knows that the stock is worth $1.50, why offer it at anything less?
But if an investor buys a stock at $1.50, having been told that’s what it’s worth in one year’s time, then why buy? Where’s the upside for the investor?
Coming back to the real world, what actually happens is that a company would be advised at what price investors are likely to be prepared to buy given they can see the potential for upside. Stock analysts might all agree that the stock is probably worth $1.50 but may then advise the company that they would have to issue at $1.00 before anyone is going to be interested.
Investors will buy a stock only if they think they can make money out of the investment.
Now let’s return to a stock that’s already been listed for a while. We know that the share price of that stock never stands still, but ebbs and flows over time. Occasionally it makes very sudden moves in either direction when a new piece of information is revealed, but even those sudden moves feature buyers and sellers all the way along. While one investor is buying because he believes the information implies a higher price for example, another is still happy to sell because he has already made some money. How much is enough? Clearly for anyone to be selling while others are buying, he or she must believe that there is a risk in not taking profits when the opportunity is presented. The buyer on the other hand believes there is a risk he or she will miss out on upside if he doesn’t get in now.
In short, the buyers and sellers have different agendas based on different views.
How can they have different views if all “the same numbers and information” is equally available to everyone?
Let’s break that down. What, exactly, are the “numbers”. How about we take a fictitious copper mining and exploration company as an example. Let’s call it Aussie Copper Ltd, with an ASX code of COP.
We know that last year COP earned $100m after tax. We know that it did so by producing 1 million tonnes of copper and selling 80% of it. We also know that profit wasn’t entirely revenue-based, because COP also started building a new processing plant and began initial exploration on some new land, where samples show there is copper. To do this it borrowed money from the bank which increased its gearing to 60%. We know that it currently has $500m of capitalisation based on a share price of $1.00 as it was at the close of the financial year. We know that it paid a five cent dividend.
(By the way, please don’t anyone pick me up on these numbers and how they correlate – I’m just making things up on the run.)
We know that COP’s proven reserves of copper are 20Mt and we know that unproven reserves total 10Mt. We also know that COP owns mines in Australia but also in Liberia. We know that the copper price at the end of the financial year was US$2.00/lb. We know what COP’s expenses were for the year, including how much it paid to lease equipment, how much it paid a mining services contractor, how much it paid its mine-workers and office staff, how much rent it paid on its Perth office, and so on and so on.
All of those numbers we know. So what is the “information”.
We know that COP has plans to expand its operation in Liberia given copper prices have been on the rise. We know that the mining services company put its prices up last year and, given strong demand, will probably do so again soon. We know that mine-workers are becoming increasingly difficult to find, and are demanding more pay. We know that the oil price is on the rise, and that last year COP consumed quite a lot of oil as welling was drawing quite a lot of electricity. We know that COP would suffer a cost were a carbon trading scheme to be introduced in Australia, and we know that this may not happen if a new government wins the upcoming election. We know that the Opposition is now ahead in the polls.
We know that the bank who lent COP the money is a sound one.
Okay Mike. Taking the numbers first, we can “look back” and see just why COP was trading at $1.00 when the accounts were rounded off last week. We can say, with hindsight, that $1.00 is about where the price should be given those numbers. But stock market investing is not about looking back.
Stock market investment is about looking forward.
We buy a stock in the hope that its share price will rise in the future. For COP’s share price to rise, the company must, in simple terms, earn more money in the future. Will COP earn more money in the future? Well that’s where we take the numbers we know (hindsight) and the information we know (includes foresight) and make our valuation (or get a stock analyst to do that for us). If the future valuation we arrive at is higher than the current share price, we buy the stock. If lower, we either sell the stock we have some already or don’t buy any if we don’t.
So how do we arrive at that valuation? We take everything we know, run it through our model, and out pops a number. The most fundamental input is what we think the company will earn in the future, or the “earnings forecast”. How could we arrive at an earnings forecast for COP?
Well that will depend on the amount of Copper COP produces, the amount it sells, the price at which it sells, which depends where the copper price will be in the future, the cost of producing that copper, which will depend on the price of oil, electricity, plant, equipment, labour, leasing, rent, services etc etc. In short, it will kind of depend on a lot of things.
But COP’s future value lies not just in what it can produce this year, it lies in what it can produce in years to come. Samples and surveys suggest that COP’s mines have reserves left of X, but we don’t know that for sure, and as for its exploration sites, well the preliminary signs are good but COP spent a lot of money on another site a couple of years back and found nothing. If this new site COP is particularly interested in happens to find the next great world copper source, then COP’s share price will go to the moon. If, again, nothing is found, its share price will retreat.
Then there’s that small matter of carbon trading, which will result in some sort of cost to COP if it gets up as a policy, but we don’t know how much yet. And that will depend on who wins government, which is a bit up in the air. And there were also rumours – unsubstantiated – that Liberian Marxist rebels were planning a coup and would nationalise all industry, no matter who the sovereign owner, by force.
Then there was this talk that the world’s oil supply might be running out, and that oil could go to US$200/bbl. Others say this is rubbish, so we’re not sure who to believe there.
We also know that BHP has been undertaking some major exploration in the adjacent but as yet untapped site to its world class Chilean copper mine. Word is that if BHP finds what it’s looking for, there goes the price of copper.
Someone also said that these CDO thingies that seem to be a problem for a US investment bank are not just a storm in a tea cup, but eventually might bring the world’s financial system to its knees, and stop any bank from refinancing any loans, particularly in the risky mining sector. Seems a bit far fetched to me.
Are you starting to get the idea now Mike?
As much as they might like to think they are, stock analysts are not omniscient.
How many variables did I just list that might affect the future price of COP shares? How many of those variables fit in the category of “the same numbers and information”. How many opinions were involved? How many future outcomes were simply un-knowable?
Do you follow a footy team Mike? Are you in a tipping comp? If the answer is no to both, I’m sure you’re aware that every year newspapers gather footy “experts” to give their tips for the year, and every week they provide their tips for the round and the newspaper keeps a tally. At the end of the year one “expert” wins, while all the other “experts” have to concede they were wrong about a few of those games.
But everyone started with “the same numbers and information”. Okay – footy is about sport which is an esoteric pursuit. Some might even call it an art form, which is very different to the number-crunching world of stock markets. But is it really that different? Don’t both have just as many variables, just as many unknowns at the beginning of the season/financial year?
The short answer to your question Mike is that stock analysts are only human.
Armed with the same numbers and information, both known and unknown, both predictable and speculative, two perfectly capable stock analysts can be easily forgiven for coming up with two very different future price predictions.
Depending on whether that price prediction is higher or lower than the current trading price of a stock, one analyst might recommend a Buy and the other a Sell.
And if someone was a legendary picker of stock prices, someone who just can’t seem but to always get things right, would he or she decide to work as stock analyst, so he or she can just pick up a salary, and perhaps a bonus, for the privilege of telling Mike how he can make his fortune? Or do stock analysts decide to work for just a salary because they don’t totally trust themselves with their own money?
Does Warren Buffet sell stock market analysis or does he just buy stocks?
But wait, there’s more.
You have identified “the same numbers and information” as being the only factor behind a stock’s price. I have pointed out that those numbers and information include a vast array of unknowns, any of which could have a material effect on a future stock price, and many of which can come down to a simple matter of opinion. But what about market sentiment?
We’ve talked about earnings forecasts. You may have heard about price/earnings ratios. A stock’s PE is its current share price divided by its earnings, and its “forward” PE is its current share price divided by its “forecast” earnings. Given the amount of variables involved in forecasting earnings we can understand why any two analysts might arrive at a different conclusion. But just how high a stock price can really run, or just how far it can fall comes down to market sentiment – and market sentiment is a purely human condition.
Investors will pay more for a stock in a bull market than they will in a bear market given exactly the same earnings result.
In bull markets, Australian investors are happy to pay 15 times the forecast one-year earnings value (price/earnings) of a big Australian bank. In a bear market, Australian investors may only pay 8 times – for the same bank, even if the earnings are the same.
Of course, if you take right now as the example, clearly Australian banks are going to earn a lot less in FY09 than they did in FY07. So the earnings numbers have fallen and so too have share prices. But in mid 2007 Australian investors were happy to pay 15 times those earnings but now will only pay 8 times the lesser earnings. So bank share prices have lost twice – once in actual earnings and once in a reduction of investor sentiment. The multiple of the two provides the share price. What drives investor sentiment?
Or should we just ask why do we fall in love? The answer’s much the same. But realistically, investors get over-excited in bull markets when it appears there’s free money to be made and overly terrified in bear markets when they think they might lose the lot.
So tell me, is share price forecasting an exact science? Of course it’s not.
And that’s why a stock market exists in the first place.
In answer to your second question Mike, I direct you to the FNArena Superstore on the website, in which one can pick up a copy of the “Aspiring investor reading guide”. Of course, any bookshop keeps a whole wall full of “how to” guides for prospective investors.
And to defend FNArena in the face of the “how do differing opinions from brokers help me with my investment decisions”, consider that FNArena is not a licensed advisor. Our service simply provides the investor with a range of opinions, which we endeavour to explain and often critique, and also correlate to arrive at what one might call an “average” view. FNArena arms the investor with a wealth of knowledge from which investment decisions can then be more informatively made.
The rest is up to you Mike. No one can tell you next week’s Lotto result with any degree of certainty.
Cheers and good luck.
Greg
