Navigating the investment world is hard — even for the professionals. For everyone else, it’s tougher still when the advice comes wrapped in jargon and spreadsheet-speak.
I’ve seen analysts talk down a company’s prospects but still rate it a ‘buy’ because their model said it was cheap.
Other times, they’ll rave about a business but stop short of recommending it because the price looks a bit rich.
It’s not easy predicting share prices and things often fall into a grey area, but what are we supposed to do with those mixed messages?
Many share investors will have come across these reports on specific companies.
They’re packed with information and can be a great resource for learning about a company, its growth prospects and the risks it faces.
The job of the analyst behind the report is to become an expert on the company and the industry in which it operates.
To achieve this, they visit factories and sites, talk to executives, competitors and customers, while conducting extensive analysis on the broader industry as well.
They learn as much as possible about each company’s strengths and weaknesses, and share these insights with their information-hungry clients.
An analyst’s report on a company will usually contain a recommendation that summarises their opinion on the shares.
The most common terms are the traditional “buy, sell or hold”, but sometimes you see the likes of “overweight” or “outperform” used to reflect a positive view.
Many also contain a “target price”, which represents the price the analyst believes the shares will reach over a certain time frame, which is often about 12 months.
Generally, a target price that is above the current share price is accompanied by a buy recommendation and vice versa for a target price that is significantly lower.
When a target price is close to current levels, you end up with a hold or neutral rating.
Everyday investors often zero in on the recommendation and target price. Ironically, these are two things professional investors tend to gloss over.
This group is likely to be more interested in the detail of the report and the nuanced messages within, which might provide a new perspective they haven’t considered.
They’ll also be curious about what sort of assumptions the analyst has made, and they’ll use this expert as an additional information source or a sounding board to cross-check their own views.
Professional investors and fund managers are more than capable of making their own buy and sell decisions.
That means they’re more likely to judge an analyst on the insights they provide, rather than their ability to predict whether share prices are going up or down.
A huge amount of time and effort goes into valuing a company. Complex financial models are built that forecast future earnings over many years, while potential risks and opportunities are assessed and estimated.
Tweak one of these variables and the valuation can shift dramatically. Even the most academically minded analyst will admit that a model is only as good as the assumptions behind it.
No model could have predicted COVID-19 or today’s shifting global trade tensions—which just shows how limited these forecasts can be.
This makes the modelling and valuation process rather imprecise, and it is as much an art as a science. As the British statistician George Box famously said in the 1970s, “all models are wrong, but some are useful”.
Analyst reports can be very helpful when gathering information and trying to learn about a company.
However, investors should take a more holistic view when choosing which shares to include in their portfolio, rather than relying heavily on the recommendations and target prices they might see in such reports.
They can help guide your thinking, but the best investment calls also weigh up things like leadership quality, balance sheet strength, dividend growth potential and any strategic opportunities the business might have.
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Mark Lister
Investment Director
Market Insights enewsletter
Keep up to date with our fortnightly Market Insights enewsletter. Our research team provide timely and regular commentary and analysis on market developments, understanding investment jargon, and the impact of current events.