Various factors might deeply influence the future of the stock research profession. I see three main negative
factors for the short / medium term future, but also two rather positive ones for the long term.
Three short term negative factors
1a. The general stockmarkets and economic picture:
After being exaggeratedly popular and
buoyant, years after years, in the 90's, most stockmarkets in the world have been falling dramatically from mid 2000 to 2003
In parallel, the world economy is encountering problems and risks,
after an excessive debt-based growth and some misallocation of resources, particularly in
the ""new economy"". Various corporate accounting scandals, and related
bankruptcies, added to the picture. Not talking about the new geopolitical environment.
No wonder that stockmarkets and stockmarket
professions have became less popular, even if there is some reprieve at the moment!
1b. Conflicts of interests:
For various investment banks and stockbrokers, various conflicts of interests appeared in full light, between:
-
their security analysis services (research and recommendations),
which get few direct revenues (by selling the analyses)
-
their stock selling activities. They include the brokerage
activity (to the public, to other institutions such as investment funds). And the money management activities. They bring customer fees, which
fund indirectly the analyses activities.
-
their corporate / investment banking activities,
bringing their own revenues, helping also to pay for the analysis services.
As a result of this
confusion and its effects, the stock analyst profession has been,
among other professions (auditors, fund managers, listed firms' CEOs...) put into accusation.
The "smoking gun" was that the recommendations that analysts gave to clients have been
generally poorly performing. Not to say misleading, once stock became grossly overpriced. One reason usually given was the insufficient respect of a "Chinese wall"
between stock research and the corporate / investment banking activities, as seen above.
But there were also other biases, that might have played a more crucial role:
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1) The "other" missing wall
A
wall between research and selling is missing, as sell-side analysts are involved in boosting stock selling (with
bonuses based on their selling targets). It seems to be their main source of revenue, more sizeable than the income from investment banking
activities. As a result, consciously or unconsciously:
-
they focus less in fundamental analysis and more in the search of
investment "ideas", as front-office sellers pressure them to supply all the time new short term tips.
-
they have an incentive to boost stock prices. As a way to
enhance their predictive reputation, and to give immediate satisfaction to the investors they advise. This might explain why
they gave many more buying recommendations than selling advises.
2) Closeness with listed firms.
This explains also this bias toward positive recommendations, as security
analysts might be over impressed by the listed firms they frequent.
The more closely you frequent those firms, the
more you absorb their culture, lose your distance, feel like a partner.
The less critical and the more overconfident and overoptimistic
(illusion of control / of knowledge) you become.
Also, many security analysts might have felt that
giving negative opinions would offend those firms. They ran the risk
that their CEOs and CFOs would consider them as enemies and dissidents
and decide to make them personae non grata, which would cut their source of information.
3) Groupthink (peerthink).
It is pervasive in stock analysts circles, as seen often in other
professions. Many analysts seem enslaved in following the ""consensus"" of their peers. It could be
-
A path towards personal "safety" ("better be wrong with everybody else than to be right alone"). This was institutionalized by
the benchmarking practice. Analysts and fund managers are appraised on short
term results, compared to those of their colleagues. A thing that
contradicts the paradigm (which also has its own biases by the way) that
stock investments are a tool for long term return performance.
-
Or
just a symptom of pure herd instinct, a widespread trait common to most
human beings, who are ""social animals"" as Aristotle said.
4) Market reflexivity.
Analysts, when assessing price objectives, often gave more attention to
the exogenous picture (market trend and prices) than to the endogenous
(economic) valuation factors of the firms. This led to over optimism.
Such a practice might have been helped by the "market efficiency" credo, which states that market prices always
reflect real values. Also that over optimism has been boosted by the
fantasy - sorry, the paradigm (!) - that a 15% return on capital and/or
a 15% yearly earnings growth should be expected for the eternity ahead.
Those two kinds of ""rationalization"" of irrational beliefs made for
illusory stock price objectives.
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1c. Investors attitudes.
Many investors suffered from that
situation once the bull run hit the wall.
As a result, they lost in a
big way their confidence in the stockmarket and in financial institutions.
They are now less enthusiastic to put money into stocks, and more conscious of the
risks and traps involved, to the point of becoming excessively risk averse.
For the future, prospects of fast economic growth and spectacular stock price gains seem
to have faded, maybe for several years ahead, if not a decade, at least in some parts of the world.
Of course, some selective
investment opportunities will inevitably arise, but stockmarkets have lost some of their
luster and appeal. As everybody knows, it is faster to lose trust than to build it up again.
The number of active investors has dwindled, and might stay low for a prolonged
time. The effects for financial institutions, and mostly for brokers, are of two kinds:
1) The market for their business shrank, and it might not recover
quickly. This leaves them with less money available for their (costly) financial analysis
services.
2) They have to face rising problems of legal responsibility, and
are submitted to new obligations, among them to isolate analysts from their other activities.
Two long term positive factors
1d. More sophisticated
investors
A new class of investors
arose during the buoyant years. But it was often lured by technical analysis methods, a thing
propitious to herd instinct. Also
fast communication reinforced their tendency to go along with the trend, however excessive the level reached by market prices.
But among them, some more sophisticated / educated ones appeared. Those
who are still active and who learnt the lessons might be readier now to make, use and
peruse fundamental analysis, instead of waiting for advises and tips, or following
mysterious graph patterns.
Also, since Daniel Kahneman was awarded a noble prize in 2002,
as a pioneer in behavioral finance, financial analysts as well as investors might be more
interested in understanding the market anomalies and the psychological biases that causes
them.
That evolution
towards more sophistication would help to refine the stock research
methods, and create new information
needs for investors. Those new needs offer new opportunities to the
profession. If it adapts to them.
1e. The Internet has
become an important
media for financial services:
1) It plays a more and more important part as a diffusion tool for
financial information.
2) This role will be strengthened if brokers will have to give less
advises (or information that might be construed as advises), via their sellers, because of the legal responsibility involved
(see 1b/1c). This opens the way for more independent information and analyses.
3) After a period where most things in the web were free, people
start to get used to pay for information and other services found on it. One of the
first sectors where this evolution is taking place is finance.
There is a new market
for value-added research services, paid by investors, mostly on the Internet.
The new needs for investors (which should be checked, by making adequate
surveys) seem to be that:
2a. Financial institutions isolate their
stock analysis services from their other activities, and even from selling (see 1b/1c), by
creating ""independent"" structures to host their research teams.
2b. Those information and analyses
be diffused, not via sellers recommendations, but independently, on paper, or better by
Internet, which allows instant access / update.
2c. Those analyst reports and
conclusions be invoiced to clients separately of brokerage fees. Thus, analysts,
getting revenues independently of the volume of the clients' operations, would have
less incentive in inducing them to be overactive and multiply
their stock operations just to create turnover.
2d. More generally, buy side research gain importance comparatively to sell side research. As a buy side
practitioner said, such a business model based on paying research is not very easy, and thus some ""starting
help"" would be needed.
2e. They include, to justify the selling
price of those research reports, elements bringing more added value
to clients. For example, more detailed economic projections
could be given and more sophisticated valuation
and risk appraisal techniques could be used, as we will see in 3c.
2f. Brokers be cautious in giving
advises / recommendations to their clients. And here I will introduce a bit of controversy:
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1) It seems abusive, however popular and
usual it has become, to give buying / selling recommendations, or to communicate stock
price ""objectives"". This is the responsibility of the investor himself, after
examining information and analyses. Well, maybe I have the ""those
who counsel are not those who pay for the mistakes"" bias
2) It is not certain that
people unable to analyze and decide by themselves should be encouraged to invest heavily
in stockmarkets, whatever the famous statistically-backed fantasy that states: ""in
the long term, it is the best investment"". |
3a. Proper legal structures should be
found for the ""independent"" research teams that would sell analyses to
investors.
They should not get revenue from the corporate / investment banking
activities (which could have a perverse effect, as seen below). Ideally, if
we go one step further, they should not be any more financially dependent of
the financial institutions.
However, things might not go that far, because of various problems. Even if some firms
make money by selling analyses to the public (Value Line...), profitability cannot be
immediate for the newly independent outfits. The analyst profession might
shrink somewhat, creating less competition and stifling research on small
caps stocks. The economic reasons behind this risk of research attrition are:
1) the cost of fundamental analysis. A full fledged stock
research service in a large financial institution costs several hundred
million dollars a year. Those costs start to be slashed, as seen
below, but stay impressive.
-
Presently, many sell-side analysts left, or were fired or got less
paid (lower bonuses). But it can be in the detriment of quality, and of quantity (unfashionable sectors
and most small caps become neglected).
-
Also a part of the job, the corporate accounts analysis, is now
more often outsourced to specialized firms, created mostly in
India for that purpose.
2) the absence of revenue from corporate / investment banking activities (the
perverse effect could be that it gives an even greater incentive to act as stock sellers so as to get more
revenue from brokerage).
3) the decrease in the number of active investors (see 1c), and
among those, of investors ready to buy analyst
reports
4) the need to offer attractive tariffs at the start to those
investors. most of them not being really used to pay a fair price, or to pay at all, for this kind of service.
Most of those firms will need therefore to receive money contributions from the
brokerage business. The main banks and brokers (in the US) pledged, in a settlement with
regulators, to subsidize during 5 years independent analyst firms.
The brokers might thus
become ""subscribers"" of such facilities. Normally, they should pay those firms a
fixed yearly subscription, based on the work done, thus not proportional to brokerage
fees. What is not clear is if those research suppliers will be:
1) Research firms made at the initiative of the financial institutions by
farming out the previous research teams. Those would go on working more or less
exclusively for their previous institution. Those institutions, via their sellers, would
use their research and advises to inform their customers, freely or for a nominal fee. The
main resource to fund research work would therefore keep being the brokerage fees, in
just a little more transparent way. This would be a cosmetic change that would not
improve much the situation.
2) Or ""co-operatives"" of several brokers / banks / funds (as merging
the existing teams might lower the costs). But that would go against competition and a
diversity of research centers, thus uniformizing valuations.
3) Or purely independent buy side firms. The financial institutions would be among their
customers, but with no exclusivity. Ideally, most revenues from those firms will gradually
come from direct retail sales of reports to investors / subscribers. This would be the
ideal solution. Although it would offer poor profitability and economic safety
for those independent firms, at least after 5 years
4) Or, for each broker, several research firms of the various kinds described
above. That means splitting a (lower) budget between several suppliers. This would lower
the selling prices of the reports. On the other hand, that will mean that each research
firm would have several institutions as clients.
Anyway, in case the linkage between analysts and bank / brokers will not be
completely broken, the other precautions stated below will be even more crucial.
3b. Analysts might have to be more
independent of their good relations with the firms they analyze.
They should not replace
their homework with what the firm communicators feed them.
This seems to preclude the alternative solution that firms
would pay for the financial analysis of theirs stocks, as they do for
auditors.
A way to be more independent of the firms' information is for them to:
-
get more interested
and extensively informed in what can happen in the macro- / micro-economy, so as to make their own forecasting of
economic trends and their effects on the firms they analyze.
-
be more aware
of the behavioral biases (of the firms, of investors, and of themselves).
-
To sum it all, get, when needed, more training not only in accounting, but also on economics / forecasting,
on business management, on psychological aspects, and of course on ethical matters.
3c. They should better focus on
""simulations"" (see chapter 4), instead of recommendations, and give more
sophisticated pricing information with their stock reports, as a way to:
-
adapt to new types of investors (1d),
-
obtain marketing
differentiation through added value (2e),
-
use more caution (2f) and stay rather informative and neutral, maybe except in
extreme cases (alerts),
Thus, as examples of the new types of ""products"" they might offer, I
suggest they provide (as illustrated in chapter 4) at the end of each report:
1) Several price scenarios. To do that necessary task would also avoid them to
be too influenced by other analysts' recommendations, and will incite them to explore all
""what if"" hypotheses,
2) Not only their ""economic"" projections / valuations (which as seen
in 1b, were often biased by the ""reflexivity"" phenomenon), but also their ""behavioral"" valuations. Those will take into account (this time openly)
the potential market biases. In other words, the valuations would combine openly intrinsic and extrinsic
calculations.
Also, those valuations should not to be given as price objectives, but as ranges
of potential prices in given hypotheses of economic conditions and market behavior,
3) A classifications of each stock in its family of risk, growth and price
behavior. This would give investors more information in order to pick their stocks (and
define their own objectives) according to each one's own preferences,
4) and - this is the closest to giving buying / selling recommendations and
price objectives - a rating (cheap, expensive...) based on the current price level of
the stocks involved. That would apply less pressure on investors and will be more neutral
in their relations with the listed firms.
3d. In parallel, bank / brokers should:
1) Control that very active customers know what investing is about and what
risks they take,
2) Offer investors more information and training in stock assessment, money
management (in the US, they pledged to provide money for that purpose) and ...market psychology.
3e. Personal ethics and legal responsibility should be stressed.
They should apply to analysts,
thanks to a kind of Hippocratic oath. But it is at least as important
that they apply also to their institutions and contractors, which are
responsible for the analyst's job descriptions, assignments, guidelines, objectives, and their control :
Analysts, for example, should be forbidden, by their contractors,
- obviously, to own stocks / derivatives of the firms they analyze,
- maybe also, to own any listed stock or derivative (except through funds).
An "Hippocratic" code of fair practices (which already exists in many
countries and institutions) would be the base for the legal responsibility of analysts and their institutions.
As seen above, multiscenarios simulations can be an alternative to recommendations
Technical remark: to calculate the stock economic value, analysts can chose any
model. Mine is close to the Bates model. I see two advantages in it: it is very
simple and it takes into account that investors, thus market prices, have a "PER bias".
Of course, analysts might chose more sophisticated economic value models. In
that case they might need to recalibrate the image coefficients that I use as a bridge
between the economic values and the ""behavioral"" potential market values.
|
Name of stock: ____________________ Simulation updated on: __.__.__ |
|
Pick your scenario
|
1 |
2 |
3 |
4 |
|
A - Estimated Economic Data |
|
. EPS 5 years
variation estimate (1) |
+ 20 % |
+ 30 % |
+45% |
+ 60% |
|
. Estimated EPS
2008 |
3.6 |
3.9 |
4.3 |
4.8 |
|
. Estimated normalized midcycle EPS
|
(2) |
(2) |
(2) |
(2) |
|
. Current or estimated. (3)
interest rate (bonds)
. Current
or estim. (3) inflation rate
|
4,0 %
1,0 % |
|
. Primary PER (see PPER table) |
11 |
|
B - Estimated Economic Values (EEV) calculations |
|
. EPS x primary PER = |
39,5 |
43 |
47,5 |
53 |
|
. Present gross dividend x 5 = |
1,6 x 5 = 8 |
|
. EEV (= EPS x
primary PER + 5 x dividend) |
47,5 |
51 |
55,5 |
61 |
|
C - Estimated Potential Image coefficients |
|
Image
stability / structural image level
+ Stock family(ies) |
low volatility / medium level
(classical stock) |
|
. Low image
(4) |
0,80 (5) |
|
. Structural image
(4) |
1,20 (5) |
|
. High image
(4) |
2,00 (5) |
|
D - Estimated Potential Market Values (EPMV) |
|
. Low EPMV (= EEV x low image) |
38 |
41 |
44,5 |
49 |
|
. Structural EPMV (= EEV x struct. image) |
57 |
61 |
66,5 |
73 |
|
. High EPMV (= EEV x high image) |
95 |
102 |
111 |
122 |
|
E - Price / value rating simulation |
|
Current price. Current value ratings |
88 |
Abs: 3 / Rel: 4
(6) |
Footnotes:
(1) in current money value (not deflated)
(2) theoretical data that may be used to refine
comparisons, but the market does not take it much into account, often the
contrary.
(3) you may use estimated rates instead of current ones if you expect
important forthcoming rate changes
(4) the narrower (=with the least stocks) indexes such as the CAC or
DJ, are a reference for many operations.
The stocks belonging to this "exclusive" club have
a liquidity and notoriety above the whole market.
Thus their prices enjoy a specific quality premium, with images
about 10-25 % higher than the whole market's image shown in
B table.
(5) the low / high image bracket could be the same in
each scenario even if, more often, images tend to be high when EPS are rising and
low when they are falling.
(6) 1 = very expensive, 2 = expensive, 3
= rather expensive, 4 = average, 5 = rather cheap, 6 = cheap, 7 = very cheap;
Abs = in absolute / Rel = relative to the whole market level
(this supposes to have made a current price rating of the market, see
SP 500 sim).
1. The new situation, with its negative and positive factors