Use Analyst Reports - But Not Their Price Targets

Analyst reports can be helpful - as long as you stay away from price targets

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I am currently reading “Value Investing with the Masters,” a book from the early 2000s with a collection of interviews. I have come across a consistent theme in the interviews as it relates to using outside research – namely Wall Street analyst reports – that I think is worth exploring.

First, Jean Marie-Eveillard:

“We look at outside research, but we don’t trust anybody. There is a conflict of interest associated with investment banking and research. Most of the research is done for growth investors who are looking for securities to move into today and out of in six or nine months. That’s not the approach we take. We have a turnover ratio of 20%, which means that on average, we hold securities for five years.”

Second, David Dreman (Trades, Portfolio):

“Wall Street analysts know their companies. You should cut a research report in two. The first part, the information about the company and its prospects, is probably pretty good. The second part, the recommendation, should be used as kindling. We use analyst information, but we don’t use the recommendations very often.”

I think these comments speak to something important: in my experience, Wall Street research reports are generally quite good. I am lucky to have access to Goldman Sachs' research reports through my employer, and their work is very impressive. The analysts are usually focused on competitive dynamics that are relevant to long-term investors; they do the groundwork necessary to ask – and answer - important questions. For example, Goldman’s tech analysts recently completed an in-depth report on the future of cloud computing and its potential impact on the information technology (IT) industry. As part of that report, they interviewed chief information officers (CIO's) and chief technology officers (CTO's) at large enterprises. They looked at the positioning of key players and discussed the dynamics that would determine the winners five to 10 years down the road. I walked away from their report with a deeper understanding of Microsoft (MSFT, Financial), Alphabet (GOOGL, Financial) and Amazon’s (AMZN, Financial) competitive positioning in a critically important market.

Where I believe the analyst reports become a bit silly is in their price targets (generally 12 months out). The issue, as noted by Eveillard, is that they are a bet on short-term market movements.

At the same time, analysts are not looking to go too far out on a limb; there is limited upside when you are right and a giant spotlight pointed at you when you are wrong. As a result, they tend to hang out within spitting distance of the current stock price (if you are looking at these reports often enough, that's likely anchoring your target near today’s price as well).

When Mr. Market becomes unnerved, this can require some acrobatics. Adjusting earnings estimates alone will rarely get the job done if a stock moves up or down by 25%. If you hope to keep up with the wild swings in the stock market, there is really only one way to get there: tweaking the terminal multiple in your model.

We can see a good example with Yelp (YELP, Financial).

In early February 2016, Goldman’s analyst had a price target for YELP of $18 per share – roughly 15% higher than where the stock was trading when the report was issued. The rationale for that price target was largely based on an earnings multiple of 11x 2016 EV/EBITDA.

Over the ensuing six months, YELP stock went on a tear; it now trades at $38 per share.

When Goldman released its report in early November after YELP’s third-quarter earnings, their price target had climbed all the way to $42 per share – roughly 17% higher than where the stock was trading when the report was issued. The rationale for the new price target was largely based on a single change: the analyst now assumed a multiple of 20x 2017 EV/EBITDA – nearly twice as high as the multiple used nine months earlier. The actual estimates in their model for 2017 and 2018 (namely revenues and EBITDA) had not meaningfully changed from February.

Going from 11x to 20x is a pretty big move. But the analysts cannot be blamed: if they wanted to keep up with Mr. Market's wild ride, they simply did not have any other choice.

Conclusion

As an investor, I think it is a mistake to completely write off analyst reports. You shouldn't throw out the baby with the bathwater. With that said, it is important to recognize the futility in trying to outguess Mr. Market on short-term swings in his willingness to pay for a dollar of earnings.

If you can stick to the first half of the analyst report, I think you are likely to find that they can actually be quite helpful.

Disclosure: Long MSFT and YELP.

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