Stock Market and Investing and Investment Advisers and Wealth Management

SKARBECK: Cheerleaders and analysts share optimistic outlooks

September 4, 2010

Ken Skarbeck InvestingIn a recent address on the subject of managing higher education costs, Indiana Gov. Mitch Daniels chastised college trustees by declaring, “You are not there to be a mindless cheerleader.”

Investors could very well borrow that same idiom to scold the vast legions of Wall Street security analysts. A recent report from the consulting and research firm McKinsey & Co. detailed the propensity for investment firm analysts to repeatedly issue excessively optimistic earnings forecasts.

The McKinsey report revisited a similar study the firm conducted in 2001, titled “Prophets and Profits.” That report concluded that, from1985 to 2000, analysts had forecasted earnings to grow at an estimated 22 percent annually, while the actual earnings growth achieved by Standard & Poor’s 500 companies was much less, averaging 11 percent a year.

McKinsey’s 2001 report also cautioned corporate executives to refrain from “earnings management” to meet analyst projections. In the aftermath of the 1990s go-go markets, many observers concluded that some CEOs had stretched too far to meet stock market expectations.

Chasing higher growth rates, companies had engaged in overpriced acquisitions and aggressive accounting, which for a time created the illusion of growth, but instead masked financial results that proved to be far less robust.

In the 2010 follow-up report, one might have thought that McKinsey would find analysts had toned down their perennial over-optimism—particularly since following the IPO, dotcom and market bubble burst, a number of regulatory measures were enacted to rein in conflicts that fostered over-hyped earnings forecasts.

Regulation FD (Fair Disclosure) in 2000 prohibited selective disclosure of material non-public information, and the Sarbanes-Oxley Act in 2002 contained provisions intended to restore confidence in security-analyst reporting.

The Global Settlement of 2003 cost the 10 largest Wall Street firms $1.4 billion in regulatory fines, and was aimed at preventing conflicts of interest between a firm’s investment bankers and their analysts.

However, McKinsey’s 2010 follow-up report, titled “Equity Analysts: Still Too Bullish,” reinforced the findings of the first study, in that analysts continued to be over-optimistic in their projections. The study’s results for the past 25 years show that analyst growth estimates have ranged from 10 percent to 12 percent a year, compared with actual earnings growth of 6 percent.

Brokerage analysts are called “sell side” analysts because they generate ideas that are “sold” to the public. And let’s face it, cheerful prospects are much easier to sell to Main Street rather than an outlook that tempers expectations. The trick is that analyst projections a year or two out are typically bullish, yet, as time passes, analysts will reduce their numbers so that when the most recent quarterly estimate rolls around, it approximates the earnings guidance provided by the companies themselves.

Ironically, the McKinsey report concludes that the stock market generally doesn’t pay attention to the giddy forecasts offered up by brokerage analysts. Instead, stock prices behave more in line with real GDP growth. Therefore, it follows that investors and CEOs should ignore Wall Street analyst forecasts.

Investors are better off forming their own outlook, independent of Wall Street. Use conservative estimates, and patiently wait to buy at a discount to one’s forecast of the future. Such a discipline may limit your opportunities, but an attractive purchase price sets the table for future profit.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
 

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