It’s perhaps not the right time to be hard on hapless analysts, as research departments, along with their investment banker counterparts, also take a big hit in the bloodletting at investment banks.
But Alan Kohler over at Business Spectator has picked up on a remarkable — and remarkably illuminating — confession from some analysts about the mysterious business of profit forecasting.
Analysts at Australian securities house Goldman Sachs JBWere have written what Kohler describes as “a remarkably honest confession” to their clients about why analysts keep getting profit forecasts wrong in a downturn like this.
Not only that, he says: “It contains the first public admission I have seen from any analysts that it is hard to reduce earnings forecasts because they need to ‘curry favour’ with company management.”
The confession was contained in last Friday’s daily note to clients from GSJBW and was written by Sam Ferraro and Matthew Ross:
It seems they had a series of meetings with portfolio managers the week before and found that “there is some frustration” with the fact that they have been slow to reduce their earnings forecasts since the onset of the financial crisis.
Ferraro and Ross point out that GSJBW’s equity strategist, Chris Pidcock, is currently forecasting a decline in industrial earnings per share in 2009 of 15 per cent. However the “bottom up” analysts (that is, those who look at individual companies) are, in aggregate, still forecasting profit growth next year of 3 per cent and 11 per cent for 2010. One can just imagine the fund managers barbecuing the hapless bottom-up analysts on a slow rotisserie when they see this sort of thing.
To their credit, notes Kohler, the GSJBW analysts have confronted the problem head-on, and very candidly, in the essay in Friday’s daily. The four reasons they cite, he says:
– They haven’t seen anything like this financial crisis before — so they tend to “underestimate the effects of systematic or top-down developments”.
– The companies 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. 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 favour with management in order to preserve their information networks”. Everyone knew this already, but it’s the first time Kohler has seen it admitted.
– Analysts need to manage their “reputational risks”, so they “engage in herding behaviour”. That is, the costs of getting a big call wrong far outweigh the benefits of getting a big one right.
The bottom line, in Kohler’s view, is that analyst profit forecasts are “virtually useless”.
Fund managers have known this for a long time, which is why they do their own forecasts. Broker research is more read for ideas and insights, and for subtle hints about companies that are written in code. But pity the poor retail investor who doesn’t understand the code and simply believes the profit forecasts and recommendations.
Amazingly, he adds, Ferraro and Ross say they don’t expect things to improve. “Our expectation is that sector analysts’ forecasts will continue to not accurately reflect deteriorating operating conditions for many companies.”
They conclude by suggesting that clients stick with analysts that have “long track records”, rather than their “less seasoned counterparts”. They don’t, however, mention the big salaries that analysts get to produce decent research for their firms’ clients, when in fact they are just managing their reputation risk and currying favour with corporate management.
