Analyzing Analysts’ Analysis

Story Highlights:

• Analysts play a legitimate market role, providing important analysis and information about the market to its participants.
• While their earnings estimates and price targets are newsworthy, they are normally based on information already priced into stocks.
• Price targets aren't useful indicators for deciding when to buy or sell.

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Why does a stock move up or down? Because of our hopes and expectations? We wish. Does a stock move because some analyst says it should be worth "X"? Nope—though it might be easy to believe analysts have such power given some stocks' initial reaction to public pronouncements. Ah, if it were only as easy as wishing a stock up—riding a $30 stock to its $50 price target. Alas, analysts don't determine stock prices—the forces of supply and demand do. Regardless, most public firms grapple with whether or not to provide quarterly guidance (public announcements regarding earnings, profits, etc.), ultimately subjecting themselves to analyst scrutiny.

What's Analyst Worth? Not a Penny as Estimates Miss
By Peter Robinson, Bloomberg
https://www.bloomberg.com/politics?pid=20601110&sid=apQUkLyvXWSA

We agree undue emphasis on just three months of company data can cause folks to lose sight of the long-term picture, which is infinitely more important. But we also acknowledge the role analysts play in capital markets. And we're referring to pure analysts who follow other companies, not economists or CFOs.

Analysts frequently have specialized knowledge and provide checks and balances, scrutiny, and skepticism—all of which are fine for more transparent markets. However, analysts can be subject to major biases, just like any investor. Perhaps they tend to only see issues through the spectrum of their sector. For example, a Financials analyst today may feel bearish on his sector because he projects continued poor earnings, and he may extrapolate his gloomy view to the broader market, which may be healthy overall. Analysts can also find themselves in any number of situations posing conflicts of interest, ultimately skewing their analysis, and it's tough for investors to know when that might be happening.

Analyst earnings estimates and price targets are fine and dandy, but should be seen for what they are: An educated guess. We must keep in mind analysts are simply reporting their interpretation of known information. They can't report unknowns that could move stocks—how would they get that information? They can't (or shouldn't) know anything that firms don't publicly state. Setting price targets based on analysis of known information doesn't really accomplish much, because it is the unknown or underappreciated that moves stocks.

And there's no reason to expect a stock to behave radically different simply because it hits a certain target price. There are plenty of reasons why stocks rise, and if a stock hits a certain level, it may not be because of the static assumptions made by an analyst based on information that's priced in.

And suppose a stock hits an analyst's price target. Now what? Sell? But why? What if the reason for holding the stock remains intact? For example, just because earnings improved and the stock moved higher doesn't mean earnings can no longer improve. If you sell, and the stock keeps rising, you've paid a transaction fee for missing out on further growth. Not fun. Conversely, what if the reason for holding the stock changes before it reaches the analyst's target? Do you stubbornly hold on because there's a target? Or say you buy a stock expecting it to rise…and for two years it does nothing? Do you dump it? Maybe, maybe not. Maybe the next year it booms 120%. All these things can happen and more, because price levels and price moves aren't predictive.

Ideally, investors hold onto a stock until the reason for holding it changes—either something about forward-looking expectations for the broad market, the sector, the country, the sub-sector, or the company itself. Price targets are set based on priced-in assumptions and are inherently short-term focused—and certainly shouldn't be the basis for a long-term investment strategy.

The noble work of analysts should be seen merely as a basis for further scientific study geared towards uncovering information not widely known. Applying this method can help you avoid useless analysis like price targets and make you a better investor.