A popular topic of conversation among amateur investors and financial bloggers is why sell-side analysts are always wrong when it comes to their stock picks and earnings estimates. That harsh assessment isn’t entirely accurate, but there seems to be an never-ending supply of vitriol and criticism directed at analysts.
The latest round has been spurred by Apple’s third quarter results announced Tuesday. The company, in the parlance of financial media, blew past Wall Street expectations. Apple made US$28.6 billion in revenue and $7.79 per share in earnings. The consensus on Wall Street, however, was revenue of $25 billion and earnings per share of $5.83.
The dedicated Apple blogger at Fortune, Philip Elmer-DeWitt, polled 48 analysts before Apple’s Q3 earnings were announced, including professional Wall Street analysts and independent investors and financial bloggers. The amateurs were far more accurate. “An army of Wall Street analysts, backed by the computing power of some of the world’s richest banks and brokerage houses, have once again been out-foxed and out-analyzed by a rag-tag bunch of bloggers, amateurs and independent investors,” he wrote. The most accurate was a Romanian mathematician. Near the very bottom of the list were analysts from Goldman Sachs and Morgan Stanley.
So what does this tell us? In May, I wrote about some of the issues affecting sell-side analysts that might help to explain their lousy track records. Despite efforts to improve the independence of analysts, conflicts of interest still exist within financial institutions, where investment banking—not equity research—drives revenue. Analysts may also be reluctant to write a negative report about a company under coverage for fear of compromising access to management. Mostly, however, predicting the future is just difficult. To expect anyone to predict earnings estimates to two decimal points consistently is absurd.
A more cynical explanation for why analysts are off-the-mark comes from Henry Blodget, who knows a thing or two about Wall Street shenanigans. “Whisper numbers,” Blodget writes, are the real estimates of a company’s earnings potential. These numbers are not released publicly, but discussed among analysts and some professional investors. Instead, analysts low-ball earnings and release these numbers so that when the company reports its financials, both analysts and journalists can write that the company “beat expectations.” The stock will then get a boost, enriching its holders.
Blodget’s assertion is hard to verify with certainty. If anything, the academic research shows analysts are far too optimistic, which doesn’t indicate pervasive low-balling. But the focus on earnings estimates is really a distraction. The buy-side—the professional investors who actually use analysts’ services—don’t care. As I previously wrote, professional investors pay little to no attention to these metrics.
Earnings estimates and recommendations are actually a small part of what analysts do. The buy-side values analysts as sources of information, and people to bounce ideas around with. They also rely on analysts to facilitate meetings with the management of companies.
Earnings and stock picks “now rank at the bottom of the heap in terms of the things clients want from the Street, yet they still get virtually all of the attention from academics—and from bloggers and tweeters and the mainstream media,” writes Minnesota investment advisor Tom Brakke.
Indeed, a working paper from Boston College accounting professor Mark Bradshaw points out that according to surveys of U.S. institutional investors in 1998, the second most important trait they valued in analysts was stock selection ability. In recent years, it has fallen to second last of 15 items. Likewise, accurate earnings forecasts ranked as highly as fifth place in 1998, but has since fallen to dead last. To focus only on earnings and stock picks is a “gross mischaracterization of the analyst’s job function,” Bradshaw writes.
Of course, as Brakke points out, the sell-side industry is guilty of perpetuating the myth that analyst stock picks and forecasts are important. The stock target price and rating figure prominently at the top of every report, and some analysts are more than happy to tout their powers of prognostication in the media. Until that lessens, analysts can expect much more criticism in the future.