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-----Original Message-----
Tomments and Tommentary - April 19, 2000 (part 1 of 3)
This email is a special supplement being delivered free to
InvestorGuide
Weekly readers. The comments below come directly from Tom
Murcko, CEO of
InvestorGuide.com (hence the name "Tomments and
Tommentary"). Assuming you
find them valuable, I'll put together more of them in the
future, but only
when I have something important to say that no one else
seems to be saying.
If you'd like to discuss what you read here with other
investors (and me),
please feel free to post your thoughts at
http://www.investorville.com/ubb/Forum39/HTML/000002.html
Someone tells you to buy a certain stock. Do you? Obviously,
that depends on
who is doing the recommending. But how do you decide who's
worth listening
to? Do you have any idea who tends to be right the most
often, out of the
sea of analysts, brokerage houses, newsletters, mutual fund
managers,
magazines, TV commentators and people you meet on the
street? Probably not.
But the internet will change that, revolutionizing stock
picking by making
it a meritocracy. And it's already starting to happen.
The internet has increased the need for stock picking
accountability, for
two important reasons. First, the internet has created
opportunities for
commentators of all shapes and sizes to voice their
opinions. With the
increase in the number of stock pickers comes an increase in
the importance
of being able to differentiate between the good and the bad.
Second, the
internet is contributing to the popularization of stock
picking.
Conversations at your coffee shop are just as likely to be
about favorite
stocks as favorite sports teams, a very recent development
that the internet
has accelerated by enabling individuals to do their own
stock research. With
an increase in the number of people looking for stock
recommendations comes
an increase in the importance of being able to differentiate
between the
good and the bad.
Everyone's rating stocks, but who's rating the raters? Until
recently, the
answer has been: virtually no one. Fortunately, while the
internet is making
stock picking accountability more important, it's also
making it more
feasible. A new breed of upstarts are using the internet to
bring order to
the chaotic world of stock recommendations. In this
three-part essay, I will
review each major category of stock picker, summarize that
category's
current level of accountability, its performance, and why
that performance
is suboptimal. I will also describe the web sites that are
working to bring
accountability to the area and how much success I expect
them to have.
- - - Analysts - - -
Current Level of Accountability:
Low. Who are the best analysts? You probably don't know, and
neither do I.
Magazines and newspapers occasionally publish rankings of
the best analysts,
but the lists are usually based more on reputation (deserved
or undeserved)
than on results. There is some accountability, in that you
can record what a
given analyst said and check back later to see whether they
were right.
Unfortunately, analysts don't make predictions that are
specific enough to
examine later for accuracy. Every brokerage has its own
buy/sell/hold
terminology, comprising in total more than 40 different
terms (if you don't
believe me, check out
http://biz.yahoo.com/f/bc.html#ratings). This is done
primarily in order to make comparisons between brokerages
very difficult.
What's worse, the terms don't mean what they appear to mean:
"hold" sounds
like a positive term, but is actually quite negative. To
their credit, many
brokerages include price targets in their recommendations,
but they rarely
specify the date on which they expect the target to be met.
In an extended
bull market such as they one we've been experiencing (at
least until last
week), it's very easy to set a price target 15-20% above the
current price
and just wait for the stock to creep up to meet the target.
Although a few
brokers make explicit performance predictions for each of
their ratings (for
example, Wit Capital's are at
http://www.witcapital.com/research/undrstnd_ratings.jsp),
these are in the
minority.
Performance:
Due to the ambiguity of analyst predictions described above,
I can't
quantify aggregate analyst performance, but I can cite a few
recent
examples:
- None of the 38 analysts covering Lucent notified their
clients that the
company's inventories and receivables were skyrocketing
prior to the stock's
35% drop in January.
- B2B portal VerticalNet hit an all-time high of 148 on
March 7. That day,
JC Bradford initiated coverage with a buy rating. The stock
has lost three
quarters of its value since then and now trades in the high
30s.
- Three analysts maintained "buy" ratings on Iridium even as
it lost 95% of
its share value and went into bankruptcy.
- Rite Aid, amid yet another reorganization, a cash crunch,
and accusations
of racketeering from the State of Florida, was rated by 11
out of 12
covering analysts as "hold" or better; the remaining analyst
rated it a
"moderate sell".
- DrKoop.com has fallen more than 90% and is rapidly running
out of money,
but three of the five analysts who cover the stock have
recommended it
throughout its descent.
Please note that this list is by no means exhaustive. I
could have made it
much longer, but I think these five representative examples
will suffice.
Analyst recommendations usually arrive too late to be
useful. When bad news
is revealed, analysts downgrade the stock. Good news,
analysts upgrade. But
the stock has already moved. Nevertheless, since
accountability is low, this
technique of recommending works to the analyst's advantage,
since anyone who
later checks what the analyst says about various stocks will
see that the
analyst has said good things about stocks which are doing
well and bad
things about stocks which aren't. Without exact tracking,
it's hard to
separate cause and effect.
To those of you who use a full-service broker: have they
ever given you at
the end of the year a graphical report of when their
analysts made
recommendations and revisions and what happened to those
stocks afterwards?
If you're using a full-service broker instead of an online
broker, it's
probably because you feel the information and
recommendations they give you
justify the extra cost, but you deserve to know exactly how
much those
recommendations are worth to you. It would be extremely easy
for them to
provide this information, but doing so would probably show
you that they
generally downgrade only after the bad news has already been
factored into
the stock price, and they hop on board the hot stocks only
after they've
already experienced significant run-ups. In fact, some smart
investors
actually use analyst revisions as a contrary or a lagging
indicator. If you
do ask your full-service broker for such a report, request
that they
calculate the performance starting the day after (and not
the day of) the
recommendation, since the recommendation itself often moves
the stock price.
In addition to making stock recommendations, analysts also
enjoy predicting
upcoming earnings numbers. But they have proven to be so
consistently
inaccurate that investors and commentators have started
paying less
attention to them, and more attention to 'whisper numbers',
available at
sites such as EarningsWhispers.com and WhisperNumber.com. In
fact, if you
watch closely, you'll find that when a company announces
earnings, the stock
price tends to move based on how the actual numbers differ
from the whisper
numbers, rather than how they differ from the consensus
analyst numbers.
Explanation for Performance:
Why is their performance worse than you might expect? Some
of it could be
blamed on a lack of skill, but the more reasonable
explanation is conflicts
of interest. Analysts are the primary way that a public
company draws
attention to its stock. Positive attention helps the stock
go up, negative
attention drives it down. So analysts have something of
value that companies
want: power. Similarly, companies have something that
analysts want:
underwriting business. Secondary stock offerings and bond
offerings generate
big bucks for underwriters, so there is a compelling
opportunity for mutual
back-scratching, at the expense of the investor who naively
believes that
the analyst is an objective source of information.
Additionally, analysts
who don't give a positive rating to a company will often
find it difficult
for them to get information from that company and to get in
on its
conference calls. Jeffrey Hooke, author of Security Analysis
on Wall Street,
says: "If an analyst gives a negative report on a company,
he might be more
candid than others, but he'll get cut off from information.
If he did that
to multiple companies, he'd be unemployed." The result is
that "buy" ratings
are common and "sell" ratings are rare. In fact, buy ratings
became so
common that investment banks started using "strong buy" to
try to
differentiate the real winners, and now "buy" actually
sometimes has a
negative connotation. And among the top Wall Street firms,
less than 1% of
all analyst recommendations are "sell" or its equivalent.
The exceptions to
this conflict of interest problem are the analysts who work
for independent
research companies, like Soundview Technology Group... oh
wait, they were
just acquired by Wit Capital. From Jeffrey Hooke: "Any
analyst whose firm
does major investment banking work--and nearly all of them
do--is suspect. I
don't know why the SEC doesn't ask these firms to spin off
their research
operations."
As described in the section above, analysts' earnings
estimates tend to be
predictably inaccurate. Why is this so? Most analysts have a
herd mentality.
No analyst wants to be the only one who was wrong, but if
all analysts are
wrong in the same way it won't seem like their fault;
rather, the essential
information causing the discrepancy simply must not have
been available. If
all analysts are wrong in the same way, they won't all lose
their jobs. But
if one analyst goes out on a limb with a bold prediction
that turns out to
be wrong, his/her career could be jeopardized. So they all
watch what
numbers each other publishes and they try to stay in the
middle of the pack.
Because of this, it takes time for the herd to move in
response to new
information, and so the average expectations lag behind the
latest news.
Additionally, analysts often publish lowball earnings
estimates that they
are confident the company will have no trouble exceeding (so
that when the
company does report better than 'expected' numbers, the
stock can get a
boost). The rationale is the same as for giving a strong buy
recommendation
for a less-than-stellar company: the analyst is providing
the company with
something of value, in the hope of future reciprocation.
I should point out that as with most rules, there are
exceptions. Some
analysts do provide valuable recommendations and good
earnings estimates,
and some analysts do not cave in to conflicts of interest.
If you rely on an
analyst for advice and/or stock picks and are confident that
you're getting
your money's worth, then by all means I encourage you to
stick with them.
The important point is that without a sufficient level of
accountability
it's very difficult and time-consuming to determine which
analysts are
earning their keep.
Sites Working to Improve Things:
There are a few sites working to bring accountability to
analysts'
recommendations. The most notable of them is BigTipper.com.
This site
aggregates analysts' price targets and tip sheets, and then
reveals their
track records. Choose from among the hundreds of analysts
and see a list of
stocks they recommended, when the recommendation was made,
and what the
stock has done since then. This isn't completely scientific:
it weights all
picks equally rather than giving extra weight to the
analyst's top picks,
and it doesn't enable analysts to later sell positions when
the outlook
changes. However, these enhancements would require
additional input from the
analysts, so the current system is probably the best that
can be done under
the circumstances.
Additionally, several sites and magazines occasionally
invite a group of
analysts to participate in a stock picking competition. The
best example is
MSN MoneyCentral's Strategy Lab
(http://moneycentral.msn.com/articles/invest/derby/derbsumm.
asp?primer).
Each analyst explains his/her strategy and manages a mock
portfolio in
accordance with that strategy. Transactions are recorded
along with
explanations for the trades, and performance is tracked to
see how well each
analyst is doing. I applaud these analysts for having the
confidence to put
their reputations on the line, and hope others will follow
their lead.
Also, some magazines and newspapers are adding to analyst
accountability, by
mentioning whether the analyst's firm does underwriting
business for any of
the companies mentioned in the article. This implicit
acknowledgement of a
potential conflict of interest alerts readers to take what
the analyst says
with a grain of salt. The practice isn't as common as it
should be, but
hopefully it will be soon.
I expect that BigTipper.com will continue to grow in
popularity, and that
other sites will soon offer similar information, enabling
more individual
investors to gain access to analyst performance data. The
benefits will be
twofold: analysts will be more careful and less likely to be
influenced by
conflicts of interest, knowing that their recommendations
are going on their
'permanent record' for all to see; and individual investors
will be better
able to differentiate between high-quality and low-quality
analysts, and
will be able to immediately know which ones are worth
listening to.
Coming Soon:
Part two of this essay will be delivered next Wednesday, and
will look at
two more groups of stock pickers: mutual fund managers and
columnists. We'll
review their performance, provide reasons why it's worse
than you may have
thought, and describe some sites that are trying to bring
increased
accountability to these groups. The third and final part of
this essay will
be delivered the following Wednesday, and will look at
individual stock
pickers, and a new breed of sites that are hoping to prove
that some
individual investors can outperform the so-called experts.
____________________________________________________________
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