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.
About the author:
I think Charlie Munger has the right idea: "Patience followed by pretty aggressive conduct."
I run a fairly concentrated portfolio, with a handful of positions accounting for the majority of the total. From the perspective of a businessman, I believe this is sufficient diversification.