More Confirmation that Sell Side Analysis is Generally Useless

Pity the poor sell side analyst. These guys have to be bright, numerate, articulate, and presentable. Yet they have to maintain the pretense that they are objective while acting as shills for stocks, and to add insult to injury, whenever they muster up the nerve to issue a harsh report (usually when the company is undeniably not doing so well), management jumps all over them and often cuts off access. Yet were there no critical reports at all, any pretense of objectivity would vanish.

If they weren’t so well paid, you might actually feel sorry for them.

The Financial Times’ blog Alphaville has an amusing post that recounts how even some executives at Wall Street firms are hard on equity analysts. Funny, aren’t they the ones who are responsible for this conundrum?

One James Montier of Dresdner Kleinwort offers a genuinely useful suggestion: analysts should quit making forecasts and simply analyze stocks.

From Alphaville:

Sell-side analysts are everyone’s favourite whipping boy. Even their bosses’ confidence has wavered. Graham Copley, HSBC’s global head of equity research last year told his team that their output was predominantly worthless.

The subjects of their efforts have hardly been more charitable. Sir Nigel Rudd branded analysts “stupid” earlier this year for failing to appreciate the value of Alliance Boots.

The analysts have been left to attempt to distinguish themselves by making increasingly bold (or is that spivvy?) calls to ride the bull market. Either that or they have worked try to avoid the charge of wide-eyed optimism by running with a sceptical pack — all the while risking exposure by a sudden takeover bid.

Now there’s some more bad news for the research community – albeit wrapped up with some friendly advice from inside the business.

Dresdner Kleinwort’s James Montier, a general critic, notes that DK’s own analysis of how accurate sell-side analysts have tended to be (carried out by DK’s Rui Antunes at the individual stock level) points to persistently wild over-optimism about earnings. On a 24-month horizon, this stretched to more than 90 per cent — and that holds for the US and Europe.

The impression that analysts are overly pessimistic is simply incorrect, he says, distorted by a few large sectors strongly outperforming and influencing the aggregate numbers.

But if analysts are wasting their time trying to forecast earnings, what should they do instead, he asks?

Evidence such as this has long dissuaded me from trying to forecast pretty much anything at all. Rather I believe that we should return to the days when analysts actually analysed firms and stocks.

He lays out a back-to-basics suggestion – a system devised by Joseph Piotroski, called an F score, which produces a nine-point, accounting-based ranking. For example, if a return on assets is greater than zero, score 1; otherwise score zero. If a change in gross margins is greater than zero, score 1; otherwise score zero.

Montier lays out the system in some detail in his latest note, along with evidence, from Piotroski in the US market and DK’s own in Europe, that the F-score does indeed help to identify which value stocks will have improving fundamentals and which growth stocks are likely to suffer from deteriorating fundamentals. The ray of hope for the analyst class is that, when they put their rose-tinted crystal balls aside, the evidence shows that fundamental analysis can be a source of alpha.

His suggestion for analysts stuck in a tight hole: forget about next quarter’s EPS – just stick to the facts.

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  1. russell120

    It’s not clear to me why the issue of forecasting is even worth bothering with. Are there any complex systems where humans have been able to forecast results beyond about three days?

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