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Grade expectations – The belief analysts can affect share prices is mistaken and misleading

05/04/2013

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Why do share prices rise and fall? The most basic – almost prosaic – answer is that, if a company’s share price ends the day up, there were more buyers than sellers, and if it finishes down, there were more sellers than buyers. Underlying that, there are likely to have been hundreds of different reasons why all of those people were buying and selling the shares on that day.

As it happens, neither the simplistic numerical explanation nor the multi-faceted one naturally appeals to the human brain. The former is too dull – if every story in the financial media ran along the lines that a particular share price went up yesterday because there were 129,000 buyers and 115,000 sellers, pretty soon everybody would stop reading.

If anything, however, the idea there could be hundreds of different reasons motivating people to buy or sell a share on any day is even less palatable. As we have discussed before in articles such as Simple minds, rather than understanding the complex tapestry that is markets, valuations and economics, many people prefer to reduce everything to simpler ideas with which they feel more comfortable.

The human tendency to construct simple stories as a way of trying to make sense of a complicated world ties in with what Nassim Taleb described in his best-selling book The Black Swan as “narrative fallacy”. This is the idea our flawed or incorrect readings of the past can begin to influence our view of the world and our expectations for the future – and in investment that can lead to mistakes.

Take a commonly used explanation for a share price move – an analyst’s upgrade for an increase or a downgrade for a falling share price. Undeniably, that is a nice, simple story – for some perhaps even a compelling one – but it is also likely to be incorrect and lead to some cognitive mistakes as a consequence.

The ultimate test of any explanation is if, by knowing it in advance, you could predict the event it explains. If I told you some analyst was going to upgrade the shares of Vodafone tomorrow, however, that would not allow you to guess what was going to happen to the Vodafone share price in any way, shape or form.

Analysts upgrade and downgrade shares every day but choosing to focus only on the changes that, in hindsight, chime with the direction of a share price is clearly extremely blinkered. Such a practice becomes positively dangerous when it changes investors’ expectations of the future.

Rationalising a share price move through an analyst’s action inevitably leads to a focus on upgrades and downgrades as a driver of share prices. From an investment perspective, that is extremely dangerous as it takes focus away from far more important long-term drivers such as valuation and balance sheet strength.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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