Even when analysts get all the facts right, their own prejudices and personal incentives get in the way of accurate forecasts. But enormous opportunity exists for those analysts who manage to read the tea leaves right, despite the constraints

Information is the raw material of the financial industry. Certainly there seems to be enough of it. But what does it all mean? All worshippers need high priests to interpret the entrails, read the runes, or decode the cards. For understanding the financial health of a company, this means reading the numbers.
 
But numbers by themselves are often meaningless. It is necessary to compare them to something else. Often these are expressed as ratios. We have ratios that are current. We have ratios that are quick. We have ratios of cash flow. But it does not end there.
 
Besides ratios, we have returns, returns on equity, assets and employed capital. We all like to forget returns on unemployed capital. Then things move in cycles, cash conversion cycles, operating cycles and the great business cycle.
 
The high priests of these numbers for investors are financial analysts. Financial analysts do the necessary research. They interpret the raw data churned out by company accountants and try to make sense of it. If they have good records they can be extremely well paid and a few have risen to be demigods of Wall Street. But are they right?
 
This has to be looked at from two different perspectives. The first question is whether their analysis is correct. The second is the value of their predictions. Finally we have to ask whether anyone cares.
 
As the legendary speculator Bernard Baruch said, "If you get all the facts, your judgment can be right; if you don't get all the facts, it can't be right." Analysts' job is to get the facts, but management has a very large economic incentive to convince them otherwise. To do so they use all sorts of schemes.
 
For example, the hallmark of good corporate governance and hopefully good management is supposed to be an independent board. By most corporate laws, the board is supposed to ensure that management works for the shareholders and not themselves. To be truly independent the board is not supposed to have economic incentives or relationships with the company on whose board they sit.
 
Independent directors get good marks from analysts. If a company makes an effort to recruit independent directors, analysts are happy. The likelihood that the company receives a subsequent stock upgrade rises by 36% and the chance of a downgrade falls by 45%. But what is independent? Even if there is no economic relationship, there is often a social relationship. It should not come as any surprise that 45% of the members of nominating committees on the boards of large American firms have "friendship" ties to the CEO. In emerging markets where family and State-owned firms predominate, the other board members are likely to be family members or ruling party members.
 
Then analysts can always be bribed, perhaps not with money, but there are other methods. The more a company's profits missed forecasts the higher the probability that management will bestow favours on analysts including recommending them for jobs and or helping them join exclusive clubs. Of course in countries with less diligent watchdogs, the bribes are simply money.
 
Even if analysts do get the facts, often their own prejudices and other incentives get in the way. According to a McKinsey study, over the past 25 years, analysts' forecasts on average have been 100% too high. They are also loath to predict a long-term profits decline. Analysts forecast that less than 0.2% of companies will suffer a long-term decline. In reality about a third do. A Harvard study found that sell-side forecasts were more accurate than buy-side estimates.
 
Finally like all market players analysts tend to rely too much on history. Research found that the correlation between analyst's earnings forecasts and actual growth for the coming year to be a mere 0.28. In contrast the correlation between the forecasts and the past year was 0.75.
 
With all their faults we still need someone to do the number crunching, don't we? Yes and no. Recently all stocks and all markets have this unsettling habit of correlating. So it doesn't matter if you invested in Europe, Japan or the US since 2007 - they have basically moved in lock step. Emerging markets are more volatile, but they also have consistently moved in the same direction as the developed world. There is also no difference between value stocks or growth stocks.
 
One reason for the correlation has to do with the popularity of exchange-traded funds (ETFs). Many investors just choose a sector or a market with an ETF, not an individual stock. So a good company within the ETF can get dragged down if there are problems within the sector or the market. In other words, the micro-numbers are irrelevant. You don't need to pick a stock; you need to pick a sector, an individual market or even the global market to make money.
 
Of course, the paradox is that the analyst can be more important than ever. The correlation misprices and good companies eventually will outperform their sector. So for those analysts good enough, enormous opportunity awaits.
 

(The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]).