BEWARE OF TREATING ANALYST REPORTS AS GOSPEL
Mark Lister, 10 August 2021
Trying to navigate the world of investment opportunities and risks is difficult, even for the professionals. For everyone else, an added challenge to overcome is the complicated messages that sometimes come from those of us giving the advice and crunching the numbers.
Many share investors will have come across analyst research reports on specific companies. These contain a wealth of information and can be very useful for investors who want to learn 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 these companies and the industry in which they operate. They visit factories and sites, talk to executives, competitors and customers, while conducting extensive analysis on the brooder 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 current opinion on the shares. Different terms are used to describe these, with the most common being the traditional “buy, sell or hold”. Many also contain a “target price”, which represents the price the analyst believes the shares will reach over a certain time frame.
Generally, a target price that is significantly 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, a hold or neutral rating is often present.
Many retail investors who read these reports make the mistake of placing too much emphasis on the recommendation and the target price. Ironically, these two things are unlikely to be the focus of the professional investors the research reports are primarily written for.
They are often more interested in the body of the report, 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 use them as an additional information source.
Fund managers are more than capable of making their own buy and sell decisions, so 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.
There are many factors that can affect how a company might perform, including growth rates, profit margins, currencies and borrowing costs. Changing one of these variables can have a large impact on the final answer, and even the most passionately academic analyst will admit any model is only as good as the assumptions it is based on.
There are also many unexpected scenarios that simply cannot be incorporated into such models. The emergence of COVID-19 and the events of the past 18 months are a good example of this.
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.
While these can help guide investment decisions, they should be considered alongside other important elements such as quality of management, balance sheet strength, track record, dividend growth potential and any strategic assets or opportunities that a business might have.