FOOL ON THE HILL
An Investment Opinion
Pay No Attention to the Man Behind the Curtain Bill Mann (TMF Otter)
January 5, 2000
A PaineWebber analyst named Walter Piecyk caused quite a stir last week when he made a buy recommendation and set a 12-month price target of $1000 on Qualcomm (Nasdaq: QCOM). This was quite an audacious prediction, standing out for its call for a 100% appreciation on top of an already spectacularly performing stock, and the high number itself. Now, $1000 in and of itself doesn't mean a whole heck of a lot, because depending on how a company chooses to divide itself up, theoretically most any company could have shares worth $1000. And to note, Qualcomm did split at the end of last week, pushing that target down to the more reasonable-sounding level of $250. But there again, that is mere window dressing in the scheme of Foolishly valuing a company.
(A note of disclosure on personal preference. There is a general derision here at The Motley Fool about the importance some people put on splits. And clearly, a split does nothing to increase the overall value of a company, because it has the effect of just dividing the market capitalization of a company into smaller pieces. But you know what? I like splits. I like it when a stock I own splits. It is a nice validation that the management is confident that the share value appreciation is justified. There. I said it. I like splits. Are those hounds I hear barking here at Fool HQ?)
Anyhow, I detailed my opinion on this particular analyst's work in yesterday's Rule Maker report, so I'll give my friends at Qualcomm a rest for today. I do wish Qualcomm shareholders the best, and I congratulate them on their Foolish selection of a great company in which to trust their investment dollars. Instead, let's look into the conflicted world of analysts, and why we here at the Fool tend to treat their opinions the same way a baby treats a diaper.
The truth is that there is almost no way for the individual investor to see inside the tangled, conflicted world of the sell-side equity analyst. The average stock analyst has almost as much independence of thought as a North Korean journalist. His primary, secondary, or even tertiary concern is not giving the retail customer a valid and objective analysis of the fundamentals of a company. Rather, there are several overlapping influences that override any objectivity he would otherwise show. First and foremost is the need to earn revenues for his company. PaineWebber, for example, makes a market in Qualcomm stock. In most other fields, this type of conflict of interest would seriously limit the level of credence an analysis would be given. For example, not even the most die-hard Boston Celtics fan would have given Johnny Most high marks for his objective analysis of the course of action on the court. ("He fiddles and diddles. He diddles and fiddles. Oh my God! Did you see Magic Johnson attack Larry Bird's fist with his face?!?") Great radio, yes. Objective? The Russian judge gives a 4.
So analysts cover companies not so much for the benefit of the investing customer, but for their employers. And the employer's interest is clearly on the side of not antagonizing potential corporate customers. This isn't so much a bad thing; it would just be better if the veneer of objectivity were pulled back a bit more firmly.
Investment banks make their biggest profits from underwriting bond and equity offerings by their clients. Therefore, these banks are highly unmotivated to provide a negative report on a company for fear that this would damage its ability to be kept on the A-list for future offerings. Given the choice between an honest analysis and a gravy train of future revenues, they're hopping on that train. This tendency is borne out in the fact that a rating of "sell" is almost unheard of on Wall Street. And the ones that do turn up tend to use polite euphemisms like "Source of Funds."
But there is something more than just the conflict of interest that makes the Foolish investor look at analysts' ratings with emotions ranging from mild disdain to passive bemusement to, on occasion, contempt. It is this -- analysts are not really very good at what they do. And that's got to be frustrating, because these are some highly educated, intelligent people. Burton Malkiel, an academic at Princeton who has made a career of pointing out the inability of analysts to actually analyze, tells an apocryphal story in A Random Walk Down Wall Street. An analyst put a price target on a company calling for a certain amount of growth based on the pricing of raw copper. The analyst is then notified that he has put a decimal in the wrong place, thus meaning that the basis of his analysis is wrong by a factor of 10. He lets the buy report stand, saying it sounded more convincing that way.
Now, this is an extreme case, but Malkiel then points out that his review of analyst recommendations show that over one- and five-year periods analysts have an uncanny ability to be wrong. Their margin of error for all types of companies is 31.3%, and that includes such low-hanging fruit as measuring the earnings growth of electric utilities. For high-flying stocks, the margin of error is much higher. While there is still a raging debate on the subject, there is something that should be fairly clear -- the investor who puts blind faith in the recommendations and price targets of analysts is setting herself up for disappointment.
What other issues hinder forecasters? How about the random nature of events? Can an analyst really predict them any better than you can? What if a key manager quits, dies, or retires? What if the regulatory climate changes? How can an analyst possibly know whether a category-killing technology is going to be released sometime in the next 10 years? Even competent analysts, the ones unclouded by conflict or personal frailty, cannot see through the crystal ball to predict these inflection points.
Fortunately, even though the past performance of individual analysts is somewhat difficult to track, they are closely linked to a group of investment specialists whose returns are much more traceable: mutual fund portfolio managers. Often, the most competent analysts are rewarded with the management of a mutual fund port. I don't suppose it would surprise the patient Foolish reader that the average mutual fund portfolio manager's performance has trailed the S&P 500 over the last 20 years by a measure of 2% per annum, before expenses. As a Fool you don't trust a mutual fund manager, the best and most highly compensated analysts in the business, to determine the value of a company for you, so why would you give the analysts from the same company any more credence?
All of these points are why Warren Buffett always talks about the importance of a margin of safety for his investments. This simply states that he would rather be vaguely right than precisely wrong in his growth forecasts. The reason is simple -- the intrinsic value of the future earnings of a company is a bashful beast. It cannot be predicted exactly. The best the prudent investor can hope to do is develop a best- and worst-case scenario for growth and see if the current price is above, within, or below that range.
The fact is, analysts are out to provide a superior product to their best clients, and some of them are very good at doing so. But the retail investor, even one with a seven-figure portfolio, should not forget that, in this line of work, he is not the client. Other companies are; many times, the very companies that the analysts are "covering" are the ones they are trying to attract for other business. Every time the retail stock market gets into a lather over some new coverage, we have the unfortunate effect of reinforcing the wisdom of these actions. Caveat emptor, dear Fools.