Comments to Tony Clark: Tony, thanks for thoughtful comments. I agree with most.

Over the years, Wall Street has convinced the gullible public to play the performance game so they can take the other side, thus laying off the risk on the investing public, and collecting a fee in the process. We have said for some time that risk is the only aspect of investing you can control, as return is completely out of an investors control, dictated more by emotions and expectations.

How do you propose to identify the sectors/parts of the capital markets which define set risk parameters?

The collective irrational behavior works both ways, the analysts who refuse to do a post-mortem to learn from their shortcomings, and the hopeful investors that consume the forecasts.

You can only hope that there are not conflicts of interests cronnically affecting these forecasts.

@Dr Kim Warren: As a CFA candidate, I can tell you that the curriculum DOES contain strategic material (Porter’s Five Forces, vertical and horizontal integration, the stages of the business cycle and their effects on the economic environment, impact of acquisitions, etc.). It also contains material around the effects of strategic management on financial performance, especially the impact of leverage, the accounting impacts of asset and project classification (i.e. operating vs. capital leases and SPE’s), etcetera.

Is the CFA program’s treatment of business strategy comprehensive? Perhaps yes or no. However, many analysts also have MBAs, which usually give business strategy a more thorough treatment.

At Target Investors, we only used sell-side analysts for their data, not their conclusions. They cannot say what they really think, but move their estimates up little by little in fear of being wrong and being fired. On the buy side, we said what we really thought.

@Dr. Kim Warren, Actually, level II of the CFA examination process covers it in passing. Probably not enough, but there is a recognition of a need to be familiar with the concepts.

I usually find these insights quite valuable, but the conclusions in this article simply aren’t supported by the evidence in your own charts, nor confirmed by more recent data extended through today. Is it reasonable to assume that the significant regulatory response to the technology crash and 2002 accounting scandals had so little to no effect? It would appear that analysts have been too conservative in their estimates over the last 8 years, with the notable exception of 2008.

Following Reg. FD (fair disclosure), Sarbanes Oxley, and other regulatory changes addressing conflicts of interest between 2001-03, earnings revisions have been upward sloping through 2007, as well as over the last year, suggesting analysts have been persistently too conservative in their earnings forecasts during both economic recoveries. Cognitive and emotional biases can be hard to overcome, particularly after significant market declines. Similarly today, we see that with remarkable positive earnings surprises (Q1/2010: 78% of companies beat Jan. 1, 2010 estimates by more than 16%), Reg. FD and Sarb-Ox has done more to keep analysts in the dark, than help investors anticipate future earnings.

It is true that 2008-09 was disappointing, but should the average analyst have predicted the impact of the financial crisis? Earnings for non-financials increased +7.2%, while financials lost money (-130%). Such diversion in one sector in 2008 can be misleading. Earnings forecasts have continued to be revised higher for 2010-2012 since the recession ended in mid-2009. The business cycle of the economy has the greatest influence over earnings in aggregate, so while it is too early to be sure any variance in behavior observed will persist, it would appear that analyst behavior has changed given upward sloping earnings revisions since new regulations were introduced prior to 2003.

With greater market inefficiency in limiting company guidance and preferential access, might we conclude that the stock market has become a more level playing field, thus the average stock investor has a better chance of adding value versus the guaranteed underperformance of index funds?

Unfortunately, financial regulatory reform has failed to address conflicts of interest and diminishing reliability of credit rating agencies, whose “objective” credit ratings are required for an ever-expanding number of regulatory purposes, including collateral requirements, capital ratios, and investment guidelines. How will we measure the impact of recent financial reforms a decade from now?

The fascinating part of this is that we (collectively) are not seeming to learn in the situation. Almost counterintuitive.

Fundamentally you cannot predict the future.

Regarding the comments of Dr. Kim Warren: Only a very small percentage of sell-side “analysts” hold the CFA designation. Their failures to acurately assess (or portray) the value of companies can hardly be blamed on the only organization that is actively working to improve the skills of the investment community.

The fact is that sell-side “analysts” are salespeople, not analysts at all. It is tragic that there are some investors that do not realize this and use sell-side notes in their investment decisions.

Had to chuckle at the comments of Mr Clark about Fama’s work. I assume he is referring the Efficient Market Hypothesis (a myth). Markets are either efficient or emotional—they can’t be both. And unless you are an android, they most certainly are emotional.

The conclusion that since most can’t outperform the market, that no one can, is pure hogwash. It could be described as a placebo designed to placate the majority who can’t.

Another conclusion to the findings of this article is explained in the document entitled ‘A language to discuss biases’ found on the McKinsey Web site. Analysts, like many in the investment industry are no doubt guilty of something the overview labels as “Interest biases - arise in the presence of conflicting incentives, including nonmonetary and even purely emotional ones.”

I also read another explanation that made a lot of sense. Analysts, like many economists, build their forecasts based on past performance so instead of forecasting the future, they have a tendency to mimic the past. This is true of all fundamentals; a fact which this study serves to reinforce.

Anyone in the trading industry learns early in their career that analysts’ forecasts must be taken with a big grain of salt if at all. Thanks to McKinsey for providing further proof!

I agree with your observation that analysts are making better forecasts in times when the economic trend is in the upswing. They take time and often are very cautious when the economy is in the downswing. For which reason, the best thing to do with their forecast is to use it as reference and guide in making our own economic decisions.

This article serves to reinforce the work of Fama and French and the underlying investment principles which fundamentally say, forget trying to predict the market.

Why do I say this? For the same reasons this study has found.

Very few (less than 20%) of active managers, be they institutional or individuals, can outperform the market in the long run taking into account:
1. risk
2. the cost of researching and then transacting
3. the cost of taxes paid as a result of active asset purchases and sales.

I support the view of another commenter. The increase in awareness of these fundamental, academically-based thoughts are not widely promoted. One needs to investigate why this is the case.

There is another way to invest to prosper based on the work of French and Fama using three factors (yes only three) to select stocks.

I urge people to shift their lens to take a good look at risk measurement and decide on what level of risk they want, and then select the parts of the market to give you the risk/return profile you seek. Forget trying to predict. Instead, have a methodology that works on fundamentals.

The bullishness is over in just one month. I just wonder why all the economists in the world, including McKinsey, cannot predict the dollar, euro crisis and give postmortem reports as to why it happened. Can somebody make any sensible prediction of world economy at least for one year?

My point is that when the analysts forecast they don’t take into consideration the investor sentiments and market sentiments which are volatile and skeptical in nature.

If they do take this into account, I am not sure if the analysts can ever predict movement of investor and market sentiments correctly. This is one of the reasons many investors have lost confidence in analysts, credit agencies, and consultants.

I would be curious to know if there are any management schools that teach how to predict investor sentiment?

As John Daly points out, the role of equity analysts is to drive the sales process, and to do this they have to paint “blue sky” stories about future earnings. To expect them to do anything else is naive. While consultants in general try to find way to actually help their clients improve their businesses, bankers are in the business of story telling and trying to change perceptions of value and or risk. Consultants and the general public need to be aware of this if they are to avoid being fooled—this dove tails well with the article on behavioural strategy and cognitive biases. In this case the cognitive bias appears to be that the writers of the article assumed that equity analysts are like them and concerned with getting the facts right.

@Dr. Warren, Is it possible to quantify how strategic management affects EPS as well as WHEN it will occur? I’d be interested in seeing a similar comparison to management’s guidance. EPS is such a flawed measure of company performance due to the assumptions allowed in accrual accounting. Also, simply understanding a business or the industry isn’t enough to predict a company’s earnings. Last year is a perfect example. I’d suggest reading the entire CFA Curriculum before bashing it. It has its shortcomings (EMH) but I don’t know of any “program” that is much better. Some of the most highly educated people in the world nearly destroyed an entire financial system. All an analyst (or PM) can and should be expected to do, is recognize companies that are creating wealth for their shareholders at a reasonable price.

While the results may alarm some, passive investment protagonists can take heart in their belief in the efficiency of the markets. Perhaps the analysts should heed the basics of modern portfolio theory rather than attempt to time or move the market. Regardless, if you’re an investor the results are clear: a balanced portfolio and long-term perspective will yield greater results, with less risks than acting on the advice of the analyst community.

It is interesting to see some quantitative analysis of the performance of Equity Analysts against the market. Given the actual role played by Equity Analysts however, the results should be unsurprising. It is important to understand that the real role of an analyst is to generate plausible, saleable arguments as to why a stock should be trading at a significantly higher or lower level than that at which it is currently trading. Armed with these arguments, the salesmen get on the phones to their clients and attempt to get them to buy or sell as appropriate. If all the Analyst does is tell his/her clients i.e. those salespeople, that the stock is currently trading at fair value, no business can be written, and his/her value to the firm will ultimately be brought into question. It is therefore vital to understand the frame of reference of the Equity Analyst. Although the stated job may be to “value companies”, there is a strong overlay suggesting that such valuation work should—wherever possible/plausible—allow the business to generate business off the the back of it.

Your readers may like to note that the Chartered Financial Analyst Institute now boasts nearly 100,000 qualified members world-wide, and that its Charter Program is regarded by the Economist as “the gold standard among investment analysis designations”. Interestingly, nowhere in this three-year program of study is there any requirement for its graduates to learn about strategic analysis of a business and its market environment. Nor is there any mention of how strategic management affects financial performance (see http://www.cfainstitute.org/cfaprog/courseofstudy/topic.html).

How, then, are they likely to come up with realistic forecasts? The CFA Institute has long known of this hole in their training, but interest in fixing it seems slow.

No wonder that the investors have lost their confidence in the analysts, including the credit rating agencies because they wake up only when the fire is already there, visible to the naked eye!

This analysis and article is yet another independent source that confirms that we don’t learn that we don’t learn. Predicting the future is impossible and that is why forecasts will be wrong, but we have to try anticipate what the future holds. In certain “sciences” such as politics, social, and economics the models used to produce forecasts are questionable as they are completely unhelpful and unreliable because they are not valid, yet “experts” continue to use and refine them as if precision will make them more accurate. There are alternatives that would suit the analysis better but are ignored.

I have also read the Black Swan recently and the same theme and messages come through. What is more enlighteneing is that “experts” never seem to track their accuracy of forecasts. I am pleased to have found this review of the ability of analysts to do the job they are highly paid to do. The tendency as indicated here confirms that they believe that they are better informed and have growing confidence in their own ability, yet the actual accuracy seems to deteriorate with “experience” and access to more information. It’s alarming to see this trend growing throughout the industry over a period of decades.