Tuesday, December 02, 2008

Analysts in the Confessional

So why the lag in taking earnings estimates down? NBER yesterday declared the existence of recession, yet analysts continue to be reluctant to fess up and mark down their numbers.

In an interesting article in Australia's Business Spectator this morning, two analysts confess why it is so hard to reduce their forecasts.

The confession was written by two Goldman Sachs JB Were analysts, Sam Ferraro and Matthew Rose, who, after meeting their buy side counterparts, detected some frustration. So even though their strategist was forecasting a decline in earnings of 15%, their own forecasts still pointed to higher earnings.

Here are the reasons they cite:

  • The analysts haven't seen anything like this before--hence, they tend to underestimate the effects of systematic or top-down developments.
  • Their researched companies and managements haven't seen anything like this before- A survey of analysts reveals that 25 per cent of companies that used to provide profit guidance no longer do (and guidance is all-important – see the next point, below). CEOs, they say, are chosen for their “left brain skills: optimism, ambition, hard work, focus and decisiveness. Patience and an appreciation of history are not considered virtues for these individuals"
  • Analysts seek to curry favor with management in order to preserve their information networks- Remember, that for most brokerage firms, the investment banking client is the "real" client...the individual client represents far less revenue, and hence, upsetting him/her is less onerous and career-threatening than upsetting the major client.
  • Analysts need to manage their "reputational risks" so they engage in herding behavior. There is comfort in numbers. The costs of being out in left field with a big call gone wrong far outweigh the benefits of getting the big call right.
As I said in my previous post, earnings estimates at this stage of the game may well be ignored by most participants,"I also believe that in a well-established and hopefully, late stage bear market, analysts are completely ignored and stocks will rally in the face of declining earnings estimates."

As portfolio managers, we do our own forecasts and tend to use Wall Street for idea generation rather than forecasts or recommendations. We have long recognized that many estimates are candy-coated to stroke the egos of the "real" clients rather than serve our needs. Similarly, there is a reluctance of research analysts to say "sell" or to couch it by calling a company a "hold" so as not to offend the investment banking client.

As in every part of investing, self-reliance and judgment are an important part of success.


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