The September 2012 Letter from Niels Jensen of Absolute Return
Partners tells the following story of a Dutch city (bold added
for emphasis):
"A number of years ago the local council took the seemingly
drastic step of removing all traffic lights, most road signs,
lane markers and other devices designed to control the traffic
flow through the city centre. The result? The local residents
complained at first because they felt less safe, which was
exactly the objective of the exercise. When you feel less safe,
you slow down and you seek eye contact with your fellow drivers
and pedestrians. The experiment has since been repeated elsewhere
and the result is the same - a dramatic reduction in the number
of accidents everywhere the 'naked street' approach (as they call
it) has been introduced.
What has this got to do with risk taking in the financial markets
you may wonder? A lot, I would argue. The rating agencies told us
that any AA- or AAA-rated paper was safe, just like the little
green man does when he shows up at my local traffic junction to
tell me that it is now safe to cross the street.
Human beings have an inclination to switch their brains
off when operating within a system that is perceived to be
safe.
Hence a (part) solution to the financial crisis could very well
be to make it appear as if the financial system is less safe."
When I read the bold line, one thing was running through my mind:
analyst reports. My assumption would be that many investors don't
read 10-Ks; instead, they likely look to analyst reports as a
guide for whether or not they are making a sound purchase. This
methodology is flawed for many reasons, but two things in
particular stands out to me: a difference in time frame and
anchoring bias.
Many investors are planning for their retirement; with multiple
years (or even decades) ahead before their capital will be
needed, volatility is their greatest friend, presenting countless
opportunities. Yet analysts don't see it that way; here's a
description of the ranking justification from a research report
of a well-know firm:
Definition of Investment Ratings
:
BUY: We expect this stock to outperform the industry over the
next 12 months.
NEUTRAL: We expect this stock to perform in line with the
industry over the next 12 months.
UNDERPERFORM: We expect this stock to underperform the industry
over the next 12 months.
Let's use a current example to think about this: Intel (
INTC
) recently cut near-term guidance - which, as any follower of the
company already knows, has come with its share of negative
commentary from the analyst community. Of course, this has little
to do with the important questions for a potential investor in
Intel - the analysts are simply basing their revisions on an
expected drop in near-term earnings. This leads us to an
important question: If the analyst is only concerned with the
next few quarters of stock performance, is intrinsic value
relevant to their estimates?
My answer would be no: Their job description suggests that they
should spend their time looking at market expectations and use
their own estimates as a guide to recommend a buy or sell rating
(with an arbitrarily chosen P/E ratio slapped on their estimate)
- pretty much what they do based on the reports I've read. As
I've noted in the past, one of the few advantages that the retail
investor holds over professional managers is the ability to
ignore short-term volatility; using analyst estimates as price
targets is equivalent to purposely neglecting one of your few
advantages over the herd (in most instances, the analyst who
points to temporarily unloved companies will be fired before the
turnaround can happen).
With the time frame issue highlighted, anchoring bias becomes a
legitimate concern; here are two quick examples from real-life
research as described in an article by James Montier:
"The classic example of anchoring comes from Tversky and
Kahneman's land mark paper. They asked people to answer general
knowledge questions such as 'what percentage of the UN is made up
of African nations?' A wheel of fortune with the numbers 1 to 100
was spun in front of the participants before they answered. Being
psychologists, Tversky and Kahneman had rigged the wheel so it
gave either 10 or 65 as the result of a spin. The subjects were
then asked if the answer was higher or lower than the number on
the wheel, and also asked their actual answer. The median
response from the group that saw the wheel spot at 10 was 25, and
the median response from the group that saw 65 was 45!
Effectively, people were grabbing at irrelevant anchors when
forming their opinions.
Another well-known example concerns solving 8 factorial (8!).
Except that it is presented in two different ways: either (1)
1*2*3*4*5*6*7*8 or (2) 8*7*6*5*4*3*2*1. The median answer under
case 1 was 512, the median answer under case 2 was 2250. So
people appear to anchor on the early numbers in forming their
expectations."
Let's put this information in the context of our retail investor:
After weeks of watching the daily movement in the stock price and
studying analyst price targets, we have undoubtedly become
anchored to the figures presented and have limited our ability to
take an unbiased look at the investment in question. Considering
that these analyst estimates are little more than short-term
guesses, I think one could make the argument that they do
significantly more harm than good.
My answer is simple: Ditch the research reports! And if walking
away from the analyst community leaves a glaring hole in your
ability to analyze equities, there's a good chance that you've
been kidding yourself all along and should consider the merits of
index funds.
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