Why Would I Use Analysts’ Predictions?

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In this week's Weekly Insights:

– Why Would I Use Analysts' Predictions?
– Mining: The Slow Grind Higher
– Chinese Trusts: The Problem That Won't Go Away
– Primary Healthcare: Not A Cash Cow
– Rudi On TV: The Week Ahead
– Rudi On Tour Visits Brisbane In September

Why Would I Use Analysts' Predictions?

By Rudi Filapek-Vandyck, Editor FNArena

It happened again last week. When on live television, I was explaining why investors should look at dividends plus growth to maximise investment potential from here onwards, and Sky Business host James Daggar-Nickson asked how investors can identify target stocks. Should they try to calculate future cash flows?

Well, from my perspective, I said, this is a rather no-brainer. Instead of trying to do it themselves, investors should simply subscribe to FNArena and let the analysts do all the work. Much better and far easier.

Being the founder and Editor of FNArena, one would expect me to say this. Granted: in this particular matter, I am biased. I use analyst forecasts and insights all the time.

But why exactly would anyone else follow my example?

Isn't it a truth, known by everyone in the market, that stockbrokers are simply second hand car salesmen wearing a suit and a tie, supported by smooth talk, a little knowledge of mathematics and a steely determination to pick up the phone and sell, no matter what the circumstances? And what about these analysts working for them? Don't they receive instructions to issue more Buy recommendations and never say Sell? To go easy on corporate relations?

Don't these analysts always find themselves responding long after the last horse has bolted out of the gates? Finally issuing Sell ratings when the share price has already tanked? Or an upgrade to Buy when the share price reaches a multi-year high? What about academic studies that have gone through decades of data and ratings and proven forecasts are always off the mark?

Who exactly am I trying to bamboozle?

As with everything else in finance and investing, there's a grain of truth in just about every sentence you just read, but none of it paints the complete picture. As a matter of observation: I am by far not the only one who studies and observes what share market analysts are predicting and changing. Apart from a loyal and growing army of subscribers at FNArena, about every single team of investment strategists and of quant analysts at every major global investment firm nowadays pays attention, and not because they have nothing better to do while at the office.

On many occasions, such research provides nothing less than invaluable insights, of which I will share some with you below.

But first, let's get a few things straight:

– a lot of criticism about analysts and their failings stems from vested interests. People who have their own data service, charts, tip sheet or analysis to sell have a direct interest in badmouthing the "others" in the sector and highlighting their flaws and errors, often in ridiculous fashion (on my observations)

– a lot of criticism stems from a lack of genuine understanding of how it works and why. Sad to say this, but this includes people working in the industry

– a lot of criticism is based upon incorrect info and data. It happens a lot that I hear commentators say: "and all brokers this or that" and I wonder: really? When I look it up on the FNArena website it turns out not to be the case. The finance sector has a well-engrained, long history for not paying much attention to detail and the correctness of statements. Brokers and investment advisors are not journalists and they genuinely will never be. Don't necessarily believe what they have to say in terms of accuracy. It's more often than not more of an opinion dressed up as a fact. (Plus it really is difficult to remain up to date on the latest changes and developments if you don't have access to FNArena or one of the few comparable services around)

– a lot of criticism is aired by investors who have little knowledge but a lot of faith in others "who must know everything" because it's their job and expertise. The reality is stockbroking analysts are but human, and they do make mistakes, are biased, are good and bad at what they do, and are just as much herd animals as we all are under certain circumstances. Remember that weather forecasters hardly manage to beat the flip of a coin in the accuracy of their forecasts. Most funds managers hug the index. Never take investment advice from an economist. And those smart looking business and finance journalists who always seem on the cutting edge of new market developments? As a matter of fact, they find inspiration and often insights and conviction in the research done by stockbroking analysts

Similar to those journalists, I read analyst reports and insights every single day. And I use it to my own benefit. Sometimes through work done by one particular team or analyst on a given subject or stock. Sometimes through observing market consensus.

One fine example of specific analysis recently published on a particular subject was last week's sector update on Australia's market for explosives by the team at Morgan Stanley. The analysts have identified explosives as the latest market to be hit by structural change, for existing duopolists Orica ((ORI)) and Incitec Pivot ((IPL)), and to start declining as a whole due to over-supply and changing customer behaviour. South Africa's AECI, through its explosives division AEL, recently indicated it has identified Australia's East Coast as the next opportunity to invest and expand into. Morgan Stanley predicts more internationals are about to follow suit.

One recent example of how I use consensus to my advantage is Brambles ((BXB)). The share price has essentially gone nowhere but sideways thus far this year and I think I know exactly why that is. Take a look at Stock Analysis on the FNArena website. FY15's predicted growth. Even if you are an investor not interested in owning Brambles shares, I think you should take a look and use this practical insight to your future advantage.

Below are some of the conclusions drawn from specific research into analysts' views and predictions in recent publications. I offer my own insights and observations where I see a chance to add value.

Many an investor would be surprised to experience how candid stock market analysts are when they study themselves and their peers. In a study published in December 2010, analysts at Citi readily admit there are times when analyst forecasts are pretty much useless. Having been a keen observer in the past fourteen years in Australia through FNArena, I can certainly back up this conclusion.

Let our minds wander back to 2008 when nothing seemed to stop the selling, but for a brief respite, in global equity markets. This "bear market" phase is when we all might just as well forget about trying to find any sort of guidance from analysts. They literally have no idea how bad things are to become and instinctively they wait for things to unfold, meanwhile taking a "surely it cannot get worse than this" approach. It surely can get worse, and it did just that. Making things worse is that falling share prices seem to be creating so much value… leading to utterly useless Buy and equivalent ratings. Lucky for analysts, they are not being scrutinised for past statements and views, like politicians are, or few would still have a job today.

The chart below, from said Citi analysis, shows how share price performance and forecasts for earnings per share (EPS) de-coupled in the years 2008 and 2009. But once the general context morphs into something more akin to "normal" again, those EPS estimates become more and more important to determine future share price performance. Note: this close correlation occurs regardless of the accuracy of these forecasts. Compare it to traveling with an umbrella when the forecast is for heavy rains and you end up not having to use it. It's not the accuracy that counts, it's the trend in the forecasts.

Now that we've touched upon the accuracy of forecasts, Deutsche Bank strategist Tim Baker recently published a report titled "Lessons from looking at 25 years of earnings forecasts" and one of the key conclusions Baker draws is that forecasts have become a lot more accurate (or should that be: less inaccurate?) in recent times. In general terms, the error margin is about 4% on Baker's calculations. Another factor to keep in mind is that the bias is to the negative at the beginning of each financial year.

In layman's terms, what Baker is telling us is that analysts tend to take off on a slightly too positive note in most years, and then they have to lower their projections by an average of 4% over the subsequent twelve months. Conclusion number one: don't get too spooked by downgrade cycles. It's the norm, says Baker. I can back up this view. What difference does it really make if a company grows at 12% and then later it turns out it is 8% only? Yes, you will see a dunk in the share price. Yes, you will hear all about how analyst expectations had been too high. You might even have bought at the preceding top, and now you are unhappy, which is understandable. But really, can you genuinely expect others to be nothing but perfect?

Personally, I think Baker's calculations are firm evidence as to why investors should use forecasts in their strategies, as long as they use them for guidance, not as a set-in-stone guaranteed outcome. Always keep in mind there's only so much the human mind can foresee twelve months into the future, no matter how sophisticated today's models and excel sheets are. An equally important observation is that downgrades to forecasts used to happen more in the first half of the financial year, but now they tend to happen more around mid-term and throughout the second half.

This has, on my observation, certainly been the case this year. In fact, forecasts had remained relatively stable until we moved into calendar 2014 this year. Things have become nastier in recent times, no doubt about it.

It goes without saying that Baker's numbers and observations do not necessarily apply to small biotechs and mining exploration companies, and likely not for micro-cap miners either.

I think the conclusion to draw from both reports combined is that analysts aren't too bad when the future is relatively stable. Companies have improved their signals and communication and they probably have, in general, become a little steadier and easier to predict, all else being equal. But don't ask analysts to foresee the next recession or the next market freeze; that's just not their thing.

Interestingly, Baker observes that upgrade cycles only occur during boom times, like during 2003-2007. In other times, downgrades are the norm. At this point in time, underlying average EPS growth for FY15 in Australia is, on his data, 7% only. Based upon his observation that by August next year, the actual outcome is likely going to be lower, Baker's conclusion is the Australian share market looks a tad expensive and certainly less attractive than many overseas markets.

Remember the comments I made about faulty data and observations? I stopped using generalised averages and data for such important conclusions long time ago. The Australian share market contains far too many resources and small cap stocks to take any general average as gospel. I mean, not even all members of the ASX200 are actively covered by stockbroking analysts…

On FNArena's adjusted calculations, which effectively means I remove sharp outliers at the top and at the bottom, the implied average growth pace for FY15 is circa 11%; suggesting there's room for another average year of minus 4% downward adjustment without the local share market approaching that dreaded "nil-growth" perspective, again.

Also, while Baker's observation is that upgrades to the average EPS estimate for the Australian share market seldom happen, this does not preclude that upgrades do happen for individual stocks, regardless of what part of the economic cycle we're in. If anyone wonders today as to why banks have continued performing so well despite experts calling them expensive one year ago already, then improving forecasts is an important part of the answer you are looking for.

A prior study by Deutsche Bank, released in December last year, confirmed what many observers, including myself, already knew: stocks that enjoy only Buy ratings are not necessarily a good investment. On Deutsche Bank's data analysis, stocks that only enjoy Buy ratings, as a group, perform as poorly as stocks that solely enjoy Sell ratings. In other words: analysts are very good in picking stocks that will prove poor investments, but their favourites do not perform any better. The best investments, according to this study, are stocks that are on balance Neutral rated or even slightly negative.

I have had my own bad experiences with stocks that only attract Buy ratings. Luckily, for me and for everyone who reads my market analyses and commentary, those experiences occurred many years ago. What I learned from those experiences is that Buy ratings are given for different reasons. And herein lies, in my view, the "secret".

The obvious Buy rating is for a company that has great growth potential, about to happen, and the share price is still cheap. The not so obvious Buy rating is for the company for whom investors show no appetite and the analyst cannot understand why. Because it's so cheap, he can only rate it as a Buy.

Make sure you understand the difference between the two. The second category is the key reason as to why analysts' Buy ratings end up being the joke in town.

All in all, I tend to mostly look beyond ratings such as Buy/Hold/Sell. Instead I look at price targets: why does the analyst think the share price should go to this price point? I look at consensus forecasts for rough guidance. Believe me, it seldom happens that predicted growth of 20% changes into minus 20% unless your name is Qantas, or Lynas Corp. Most of all, I look at specific insights embedded in analyst research reports. A change in market dynamics? A specific contract that seems more trouble than what it's worth? A future windfall that nobody has thought about, yet?

Anything that can make me a better informed investor/analyst/commentator.

Mining: The Slow Grind Higher

Market caps, industry confidence and overall activity levels inside the global mining industry have all likely hit multi-year troughs in the first four months of calendar 2014, and gradual improvements are being recorded by those who pay attention and record these things, but that's still no reason to get overly excited.

Sector analysts at SNL Metals & Mining observe there's a slight recovery in activity levels, but the industry remains firmly focused on late stage assets; those that are near completion. Early stage projects remain few and far between and getting funding organised remains a hot potatoe subject. Now that summer has kicked in for the Northern Hemisphere, the industry probably won't see much in terms of further recovery until we've entered the December quarter this year, predict the analysts.

Confidence that things must/shall/will pick up further from here is to a large extent based upon the expectation that prices for gold and for base metals have seen their lows this cycle.

Another interesting set of statistics was put forward by BDO's March Explorer Quarterly Cash Update. Such as the fact that 10% of the circa 800-strong junior exploration companies listed on the ASX have now ceased drilling, while a further 42% had only enough operating expenditure left for up to two more quarters.

The bottom may have been seen, but this by no means implies there's no more bad news coming from this sector. The numbers above speak for themselves. Mining services companies can weep a little longer.

Chinese Trusts: The Problem That Won't Go Away

An end to the bear market in Chinese equities and a general recovery in share prices of listed miners, plus a noticeable improvement in investor sentiment towards the sector on the back of improving China PMI reports; one would be forgiven to think the worst is over and both China and the global mining sector can now look forward to a much improved environment.

Short term movements from sold down pricing points do not tell the whole story, however. Chinese stimulus may have kept the economy en route to a desired 7.5% GDP growth this year, the problem of misallocation and over-reliance on regional property markets is not going to vanish overnight, not with the sector as a whole going through a down-cycle. And there still is, of course, the problem of Chinese investment trusts of which many, by now, should be in serious trouble. But we're not hearing or reading anything about it, so what has happened?

Luckily, analysts at Bank of America-Merrill Lynch are keeping track for us. It turns out, many more of these trusts are by now in trouble but the Chinese have been working hard behind the scenes to keep things contained, and they have been successful. So far, no defaults have been reported and BA-ML is not anticipating anything soon, but promises to keep an eye open to further monitor developments.

On the analysts' earlier predictions, Chinese trusts would see a sizeable jump in numbers of troubled brethren in May/June. This proved correct but no defaults have occurred. The next testing periods, according to the analysts, will be September and then December this year. To be continued.

Primary Healthcare: Not A Cash Cow

Now that the scare of co-payment GP visits has ebbed away, Primary Healthcare ((PRY)) shares have rediscovered upward momentum with the price jumping from below $4.40 last month to around $4.75 this week. Equally predictable, there are sector reports and quant stock tips lists appearing suggesting Primary is a must have "laggard" stock that soon will find a way to close the gap with its better performing sector peers.

What none of these reports mention, and in fact most reports by stockbroking analysts don't highlight it, is that Primary is one of listed entities with left-field accounting practices that sometimes leads to the occasional warning or public debate story in one of the national newspapers. Among the stockbrokers, Macquarie is the one that feels most uncomfortable with the company's accounting and the analysts make it clear in every single report they release on the company.

Last time the company reported (interim-numbers in February) Macquarie couldn't help but noticing free cash flows were no less than 82% lower than reported profit. The analysts didn't exactly spell it out, but the underlying critique was: this stinks and the smell is likely only getting more difficult to hide. How long before the market in general starts paying attention?

Concluded Macquarie analysts at that time: "we remain firm in our belief and whilst we cannot identify an immediate catalyst for PRY, we believe the market's patience for its poor cash generation will likely eventually wear thin". That was the last time Macquarie updated in detail on the company (further emphasising the point).

Most analysts are pretty sanguine about the whole issue, slapping a Buy or Neutral rating on the stock, underpinned by fairly positive commentary and projections and with price targets well above or in the vicinity of the current share price. Macquarie rates it Underperform with a price target of $3.80, some 20% below the current price.

As per usual: Caveat Emptor.

Rudi On TV: The Week Ahead

On request from readers and subscribers, from now onwards this Weekly Insights story will carry my scheduled TV appearances for the seven days ahead:

– Wednesday – Market Moves – Sky Business – 5.30-6.00pm
– Thursday – Lunch Money – Sky Business – midday-12.45pm
– Thursday – Switzer TV – Sky Business – between 7-8pm
– Monday – Sky Business – circa 11.20am (Broker Calls)

Rudi On Tour Visits Brisbane In September

I have yet to book accommodation and flights, but on Wednesday, September 3, I will be presenting in Brisbane twice, in the afternoon and in the evening, on behalf of the local chapters of the Australian Investors' Association (AIA) and the Australian Technical Analysts Association (ATAA)) respectively. More details to follow.

(This story was written on Monday, 04 August 2014. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Things might look a lot different today than they have between 2008-2012, but that doesn't mean there are no lessons and conclusions to be drawn for the years ahead. "Making Risk Your Friend. Finding All-Weather Performers", was published in January last year and identifies three categories of stocks that should be part of every long term portfolio; sustainable yield, All-Weather Performers and Sweetspot Stocks.

This eBooklet is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

For paying subscribers only: we have an excel sheet overview with share price as at the end of July available. Just send an email to the address above if you are interested.

Click to view our Glossary of Financial Terms