Analysts can’t seem to get it right with the Indian tech company Infosys. Five times in the last 8 quarters, their forecasts have been way off. One of the most interesting and consistent problems with analyst forecasts is excessive optimism
Analysts can’t seem to get it right with the Indian tech company Infosys. Five times in the last eight quarters, their forecasts have been way off. The result has often been a precipitous drop in the price of the stock. Is there something wrong with Infosys or the analysts?
To be fair to both, the main problem is the future. No one can predict it. If analysts could do so with consistent accuracy, they certainly would not need jobs as analysts. Although it has been said that analysts were created to make weather forecasters look good, this does not mean that the world does not want its soothsayers, we are addicted to these forecasts, so it is good to better understand how to read the entrails.
One of the most interesting and consistent issues with analyst forecasts is optimism. Forecasts for earnings growth are always sunnier in January. Forecasts for the American market index, the S&P 500, at the beginning of the year predict rising profits. For the past 26 years, both European and American analysts have predicted increased earnings although they have fallen one-third of the time.
Profit forecasts not only predict positive earnings, their annual forecasts start out higher than they end up. Over the two-and-a-half decade period, there were only three years (1988, 2005 and 2006) when forecasts ended up more positive, than at the end of the year.
Not only is the bias wrong, but often the accuracy is way off. European forecasts were off by 20% a third of the time. The US was a bit more accurate, but nothing to be proud of. American analysts were off by more than 10% half the time.
Analyst cannot forecast recessions, nor do collapsing markets seem to bother them. At the beginning of 2008, analysts’ consensus predictions were for a rise in the earnings of S&P 500 companies by 16%. Instead they fell by 18%. A 36% drop in the market in 2008 did not seem to bother them at all. Their forecasts for 2009 were also for earnings growth, which certainly did not happen. They fell again, but not by the same amount as in 2008.
One of the reasons why the forecasts are so optimistic has to do with probabilities. The markets have gone up for 20 of the past 31 quarters. The worst market performance occurred in only six quarters. So if an analyst makes a positive prediction, he has at least a two-thirds chance of being right. Investors’ memories are exceptionally short, so mistakes are soon forgotten and besides everyone else probably made the same mistake. Massive prediction short falls can always be blamed on exceptional circumstances or the infamous black swans.
Besides probabilities, there are profit motives. Brokerages and investment banks (sell side) promote stocks where they stand to make millions in fees. It is hardly surprising that the analysts who work for these firms are biased toward shares going up. Since their employers want to promote the stocks, they also promote the analyst predictions. We never hear from sell side analysts. Their employers, pension funds or mutual funds, have no interest in letting expensive information get leaked to their competitors. So the most unbiased information never gets out.
Another problem with analysts has to do with where they get their information. Investors, analysts and economists all over the world make the rather simplistic assumption that people are actually telling them the truth. The probabilities that they are will be quite small. Enormous sums are at stake. So the incentive to lie is huge. Most developed countries have securities watchdogs that are supposed to insure that the information reaching the market is accurate, timely and complete. Sadly many developing countries are not so blessed. This is especially true when the company in question is owned by the government. In the case of China this is most of the economy. The conflict of interest within the government almost guarantees that the information will be not accurate.
Management is another problem. Managers have a habit of intentionally massaging their guidance. Certainly they have large economic incentives to do so. Convincing the market that the company is doing better than anticipated often results in a rise of the stock. Many executives are also compensated in stock, so a bit of a boost never hurts managers’ compensation provided that the market actually believes you.
Managers also want to create a sense of stability. According to a recent survey 96.9% of CFOs prefer a smooth earnings path. A nice earnings graph without spikes or troughs can mean less perceived risk which translates into lower costs for capital, better credit ratings and more credibility with investors.
The credibility of guidance depends not only on the reputation of the company but also upon the type of news itself. Good news is treated by the markets quite differently from bad news. Markets tend to be sceptical about good news, which partially explains the muted reaction to this quarter’s positive earnings numbers. Apparently the market suspects management’s motives.
Bad news, on the other hand, is considered far more credible and the market has a much greater reaction. Although the likely credibility is equal for both types of news, bad news can push a company’s stock down by as much as 10%. Since the management realizes that bad news has a greater potential to spark a sell-off, the incentives are greater to err on the upside when releasing a negative forecast. Perhaps the greater reaction to bad news has more to do the cognitive bias of loss aversion which is people's tendency to strongly prefer avoiding losses probably twice as much to acquiring gains.
So what is an investor to do? The first would be to consider the source. Analysts have biases just like everyone else. It is not just their employer. They are also subject to the same effects of momentum. I have noticed that hot stocks, like Apple last year, get glowing reviews when they are moving upwards. But when the momentum shifts, so does the hyperbole.
Predictions are also subject to probabilities. We should constantly keep in mind the great English mathematician Thomas Bayes. Bayes pointed out that the probability of a specific event should be continually updated to account for evidence. So investors should be very wary of stories and especially predictions. The most important aid to good investing is to keep an open mind and avoid any specific theory about any particular stock or asset class and be ready to change your mind when the market does.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)