Sit through enough investor presentations and a number of near-universal themes begin to emerge. one common refrain from large investment houses – particularly those with origins in the US – is the alleged benefit of employing legions of in-house analysts who are supposed to be especially adept at guessing (although they tend to use the word ‘forecasting’) what companies’ earnings will be.
This is inevitably accompanied by a slide showing all the different analyst teams around the globe and, should you then be impertinent enough to ask for evidence of how good those analysts’ guesses are, you will likely be told the actual numbers do not matter. What is important, apparently, is the analysts can see when earnings will surprise or disappoint and the estimates need to be revised up or down.
This sort of answer contains a neat trick in that it assumes an element of common ground – that is, that you both agree rising/falling market estimates will result in rising/falling share prices – without having to worry about anything so awkward as evidence. People then tend to be reluctant to ask the ‘stupid’ follow-up question – do stock prices reliably rise (or fall) when estimates are too low (or too high)?
Here on The Value Perspective, we have no such qualms about asking ‘stupid’ questions, which is why we have created two charts inspired by a recent financial times article entitled ‘European corporates thwart analysts’ optimism’. It notes how consensus expectations for European companies’ earnings growth at the start of the year have – for four years in a row – proved “wildly over-optimistic”.
Source: Bloomberg and Schroders – May 2014
Past performance is not a guide to future performance. The value of investments and the income from them can go down as well as up and investors may not get back the amount originally invested. Exchange rate changes may cause the value of overseas investments to rise or fall.
Of the two charts above, the one at the top shows how earnings-per-share forecasts for the European STOXX600 index have been revised over the course of each of the last four calendar years while the bottom one shows how the index actually performed over each of those years. So how good a steer on market performance would those large investment houses have received from their analysts?
Well, to begin with, they would probably have felt pretty pleased with themselves as market earnings estimates were revised up in 2010, with the market then rising, and revised down in 2011, with the market subsequently falling. However, shorting the market in 2012 and 2013, as a result of correctly forecasting even larger negative revisions, would have undone all of the first two years’ good work.
A much more effective indicator of performance, of course, is valuation, with the market tending to rise when valuations are low and to fall when valuations are high. As David Dreman shows in his book contrarian investment strategies, this also holds true at the individual company level as stocks with high valuations show little or even a negative reaction to positive earnings surprises.
In contrast, stocks with low valuations can actually rise in price even though earnings are below the market’s expectations. Here on The Value Perspective, we would argue the time of any professional forecaster would be better spent assessing market and company valuations rather than trying to out-guess the other guessers’ guesses.