Warren Ingram looks at why they call wrong so often.

JOHANNESBURG -  One of the foundations of the asset management industry - the research provided by research analysts - seems to be fundamentally flawed. Studies have shown that for years, these analysts have been spectacularly wrong in their forecasts for the next 12 months. To compound the problem, it is well known that their forecasts for periods of three years or longer are largely worthless. One has to wonder how effective the entire industry is when one of the foundations is so flawed.

How does the industry work?
If one were to simplify the industry to make the explanation short, when you invest money in a unit trust as an example, your money is pooled with other investors' money and given to an asset manager. The asset manager then manages this pool of money according to a specific mandate. In order to make decisions about what shares to buy (as an example), the asset manager will rely on research provided by in-house research teams and external research from stock brokers. The people who provide this research are called research analysts (or analysts for short) and they are usually specialists in a particular field. So, you get economic analysts, mining specialists, food, hotels and leisure etc.

These analysts are highly qualified, highly paid individuals who are considered experts in their field. They are usually paid a very high fixed salary and bonuses, which are based on their "performance". As an indication, a top rated analyst who covers Anglo and BHP might earn an annual salary of R1m -R2m and get an annual bonus of R3m -R5m if he or she tops the ratings. One would expect these analysts to have an in-depth grasp of all aspects relating to their sectors and therefore they should be able to provide reliable information to their asset manager clients. This information includes forecasts, usually about the profits that the companies are going to earn in the following six, 12 and 24 months.

Analysts are spectacularly poor at forecasting
The chart below was supplied to me by Cannon Asset Managers and is used by them to explain why they are so wary of relying on forecasts from analysts. The chart shows the forecasted share price targets set by analysts (the red bars) and the actual share prices for the period of the forecast. This is a US study but you can be assured that the SA analysts perform to a similar standard. As you can see, 40% of the time, analysts are actually wrong about whether the share will generate a positive or negative return. Even when they correctly forecast the direction of the share price (ie, positive or negative) they are rarely close to the mark in their forecasts.

If you have ever followed economists' forecasts, you will have noted that they have a similar rate of inaccuracy with currency predictions and other important economic information. This is especially concerning because share analysts often use their economists' forecasts in their own forecasting models. For example an analyst covering gold miners will need to have a forecast for the R:$ exchange rate in order to work out the future revenue that will be generated by the company. If the R:$ forecast is very wrong then  the analyst has little chance of making an accurate profit forecast etc.

Do analysts add any value?
Many asset managers don't use external research because they place so little faith in the information they receive. Of those asset managers that use external research, many of them ignore the analysts' forecasts and  recommendations (eg, buy, sell or hold) They use the research as an information tool to keep them informed about what is happening at the company and its sector. In essence, many of the most highly rated analysts are very good at providing asset managers with current, high quality information about the underlying companies and the industry. It can be very difficult for an asset manager who covers the entire stock market to keep up to date with all the sectors of the stock market let alone all the individual shares. To this end, analysts can be very useful as they help asset managers to be more efficient. From the description above, a cynic might argue that analysts are performing the role of high quality journalists and are certainly earning many multiples more for doing the same job.

Many stock broking firms have grappled with the concept of analysts and their potential value for years. The whole industry has worked the same way for so long that stock brokers are afraid of limiting the use of analysts as they may not have anything to sell to their clients. If a small stock broking firm has a big team of analysts with impressive rankings (and commensurate salaries), the theory is that the stock broker will get a greater share of revenue (brokerage) from the asset managers. This theory does not work very well in practice. The rankings that are used to rate analysts are often very arbitrary and can be decided on a whim. Some analysts who are excellent at their work constantly get poor ratings because they are poor at relationship management. Similarly, some fund managers might like a certain analyst more (even though the analyst does poor work) and therefore the analyst remains highly rated for no good reason. Top rated analysts are often very good at client entertainment as well as being very knowledgeable about their field.

Don't rely on forecasts
People are always asking for predictions about the direction of the stock market or the rand. When "experts" are asked these questions they will oblige and tell you what they think. Remember, most "experts" hate to say, "I don't know." History has taught us that a R5 coin might be a better forecaster than the "experts" - at least your coin has a 50% chance of being right. In summary, rather don't ask for predictions because you will not be getting reliable information. If you make decisions that rely on other people's forecasts, you are sure to be disappointed.

*Warren Ingram, CFP®, has been advising people about their money management since 1996. He is a director of Galileo Capital, www.galileocapital.co.za.

Are there specific Money Matters you would like Warren Ingram to cover? Write to him at Warren@galileocapital.co.za

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hiring practices The industry needs to hire people that can think "out the box" and that are not afraid to go against the consensus...unfortunately these tend not the the CAs/conventional straight A students that follow the typical career path...look for the . .more mavericks ... . .less by Mises on November 18 2009, 06:41 Find this comment inappropriate? Report it

The Truth Warren, how could you expose all these experts! They rationalize their salaries everyday by giving expert opinion on TV and radio to all the lemmings who want an "expert" to think for them. Shame on you! by Observer on November 18 2009, 07:38 Find this comment inappropriate? Report it

Analysts Absolutely spot on Warren. I call analysts history teachers because they almost always depend on what happened in the past, draw graphs and then guess the rest. I have yet to come across an analyst or financial adviser that knows exactly what will . .more happen in the future. . .less by JvR on November 18 2009, 07:41 Find this comment inappropriate? Report it

The investment industry Absolutely spot on. Its good to see someone is not afraid to analyse the investment industry and its complex socio science web of deception. If you talk a lot of cr*p, look half intelligent and gives the impression that your a nice guy = paid a lot. . .more The power of marketing... . .less by loci on November 18 2009, 07:45 Find this comment inappropriate? Report it

The finance sector is like a leech feeding of the real economy . by Engineer on November 18 2009, 07:49 Find this comment inappropriate? Report it

Do the opposite Clearly then, by doing the exact opposite of what the 'experts' say, one would be winning ? by Pioneer on November 18 2009, 08:52 Find this comment inappropriate? Report it

Spot on!!! Analysts and economists are of the same ilk, complete waste of time. Take their rambling with a pinch of salt and listen for the sheer entertainment value, and wonder how do monkeys get paid so much?? by Indjun on November 18 2009, 08:57 Find this comment inappropriate? Report it

blah blah blah Investing is very simply about making a call on the future. Of course, the future is uncertain and forecasting accurately is inherently impossible. All analysts know with utter certainty that their forecasts will be wrong. I would rather have . .more bright, experienced and knowledgeable people trying, than not. I'm stumped as to the point of this article. Analysts forecasts are often wrong; so what? We all know this anyway. The traditional stockbroking model is flawed, as is the system of rating analysts; so what? This is also not news. Don't rely on forecasts? On what then will you base an investment? Make your own forecasts by all means, but draw on the best minds and information you can in formulating a view. . .less by Insider on November 18 2009, 09:07 Find this comment inappropriate? Report it

They are paid to sound clever and to provide a false sense of comfort hey serve ni purpose, cozzYcozz the market does not move on fundamentals We don't need them - fire the lot of them Thanks fer listening by Munch on November 18 2009, 09:30 Find this comment inappropriate? Report it

Spot on Warren Excellent article. by Francois Viljoen on November 18 2009, 09:32 Find this comment inappropriate? Report it

@Engineer Amen. Pay engineers lofty analyst salaries to get them to work analyst hours and the companies analysed will meet the lofty projections of analysts more often. There are a few maverick analyst out there that saw it coming for some of the . .more companies worst hit by the financial crisis. Find an analyst that has as many sell recommendation as buy recommendations. Sell (or even Hold) recommendations does not endear an analyst to management and does not get the firm much business. Some analysts rely entirely on relationships with company management for events and insights and therefore never says anything negative (never recommend "sell"). Most analysts also believe they are more clever than the collective market and have stupid target prices (eg 40% upside)! . .less by Analyst on November 18 2009, 09:34 Find this comment inappropriate? Report it

The SA version? Anyone able to draw a simillar graph for the SA analyst community? Maybe a local analyst can do it to show us how wrong this article is? Or not? Anyone capable and willing? Anyone? by Malcolm van Hilten on November 18 2009, 09:35 Find this comment inappropriate? Report it

Pray tell Please Warren enlighten me as to why I should then give you money to manage as you are doing exactly the same as an analyst and that is trying to predict the future. Why shoot yourself in the foot because you aren't clever enough to be an analyst ? by Oracle of Delmas on November 18 2009, 09:41 Find this comment inappropriate? Report it

Who's gonna do it then I'm a 24 year old who just finished her studies and busy with the well known CFA exams.. You really learn allot of theory and models and so on and so on.. but at the end of the day, its all about experience. Its not the easiest thing in the world . .more to do... there's so many things to consider and it's all changing everyday! everybody makes mistakes.. but to try your best and to do things to the best of your ability is the most important. I'm sure it's easy to point fingers till you sit in that position where you have to make the call! no so easy then i suppose! . .less by difficult on November 18 2009, 10:17 Find this comment inappropriate? Report it

They don't care The analysts don't care whether they are wrong or the repercussions of their calls or what society thinks of them. They earn MILLIONS-more than most directors. No one criticises what they get paid. Where is Anne Crotty on this one? Why should . .more analysts change the way they do things? It's the institutions and corporates that are prepared to pay commissions and corporate finance fees that allow the investment banks to pay these guys so much for doing so little. . .less by Jo on November 18 2009, 10:18 Find this comment inappropriate? Report it

Fixed Agreed that it's difficult to predict how share prices will move in absolute terms, but a lot of investment is about getting the relative movements right. Would love to see a study on how good they are at that. by aker on November 18 2009, 10:33 Find this comment inappropriate? Report it

buy ETF's and eliminate human deficiencies by snore on November 18 2009, 10:42 Find this comment inappropriate? Report it

Analysts I would liek to be an analyst and wear a hugo boss suit, drive a porsche and live in a massion at Sandton.... by Proudly South African on November 18 2009, 11:09 Find this comment inappropriate? Report it

Forcasting the future Anyone who believes that analysts can predict the future is just plain dumb.The purpose of the analyst is to provide credibility to the asset managers stock pick.In order to convince the public that active managers are doing something worth . .more paying for you need to provide piles of research which indicates how clever you are and how you will out perform the market.Smoke and mirrors and lots of paper...let me look into by glass ball. . .less by Flash on November 18 2009, 11:11 Find this comment inappropriate? Report it

Incorrect salary info Warren, I'm not sure where you got your salary info but it's seriously flawed. I've been working on the sell-side for many years and you can probably count on 1 hand the no. of analysts who get paid salary of 2 mill and bonus upwards of 3 mill. by City Boy 2 on November 18 2009, 11:13 Find this comment inappropriate? Report it

Well known fact It's well known that the predictions of analysts and economists are likely to be wrong. It's not because they don't care or because they're ignorant or anything like that. It's because markets and economies involve people and the degree of . .more randomness added by their involvement throws everything off. That's partly the basis of behavioural economics, which is more or less the study of why people don't believe that R1 in their left pocket has the same value as R1 in their right pocket. The problem with analysts ends up being not that they're often wrong, but that they believe they're right and don't properly understand the margins of error. An analyst will probably think along the lines of there being an 80% (or whatever) chance of them being right whereas it turns out that it's more like 15%. I find it quite amusing that studies have shown that the weather is predicted far more accurately than what's going to happen in the markets. Other studies have shown that many fund managers do worse than guessing. Nevertheless, as pointed out, the analysts aren't actually useless - they provide very good information on current situations. That information allows the readers of their reports to come to their own conclusions. Ignore the predictions the analysts make. . .less by CTheB on November 18 2009, 11:16 Find this comment inappropriate? Report it

Forecasting Good artile. however I am interested to know how you invest your money and how for that matter does Cannon Asset Managment go about investing for the future? by OBS on November 18 2009, 11:31 Find this comment inappropriate? Report it

Dismal I have recently attended two big presentations to analysts in New York and London which reinforced my dim view of analysts (I'm a company director). The analysts seemed to be more interested in the free luncheon,souvenirs and making an appearance . .more than in really understanding the company. None of the analysts had a clear idea of exactly how our business works, despite us being a very transparent company and them being sector "experts". Their questions showed little understanding of the profit drivers or strategic issues facing the company and indeed their queries confirmed their ignorance - eg "Can you provide granularity on ..." something totally irrelevant. I kept thinking that a single, modestly paid, mid-level employee in our company could provide a far better budget model and business review than this army of well-paid analysts could come close to. All the analysts really wanted to know was whether we were seeing growth and how they could develop a one line sound bite to pitch to their clients. I agree with the article and also think that analysts are closer to reporters and don't add much value. I can easily see how Enron, AIG, Wamu and hundreds of other companies are stock market darlings one day and bankrupt the next without analysts raising any red flags. . .less by Punter on November 18 2009, 12:25 Find this comment inappropriate? Report it

I wouldnt take advice from a no good "CFP" no thanks Ingram by Analyst on November 18 2009, 17:25 Find this comment inappropriate? Report it

Fundamentals The conclusion that analysts are wrong 40% of the time based on performance over 9 years is flawed, due to the small sample size. However as you correctly state, in fact analysts may not have predicted the "actual outturn" or magnitude of . .more earnings, but with the exception of end 2001/02(dot com and emerging market crisis) and 07/08 (credit crunch etc) which can be considered exogenous, the turning points were predicted by analysts in all cases. Also, how are they calculating actual US returns? To my knowledge US and World GDP grew in 2002? As for the role of analysts in an economy, you will have to be extremely lucky to consistently beat a specialist in his field. . .less by Dismal scientist on November 18 2009, 17:30 Find this comment inappropriate? Report it

CFP on CAs FIAs and CFAs! You have qualified accountants and actuaries with CFAs often with years of relevant industry experience analysing companies. These people studied many years to understand banks/life insurers/mines/retailers/ economy/ finance. They still only get the . .more big picture stuff right 60% of the time (better than the market which gets 50% by definition). What you need to analyse is stock picking abiliity of the analysts, not this big picture projections. Go figure if you have a CFP trying to analyse anything (let alone analysts). . .less by CFP CA FIA CFA on November 19 2009, 08:40 Find this comment inappropriate? Report it

Poor investors believe all CFP says Lies damn lies and statistics. CFP = certificate to faak peeple by Poor investors believe all CFP says on November 19 2009, 08:43 Find this comment inappropriate? Report it

What planet are u on Warren ?? Been smoking the wakky bakky again Ingram - there are analysts and analysts. Doctors and Doctors - Lawyers and Lawyers - the trick is picking the nest ones - would not take advice from u by Klap Trap on November 19 2009, 10:12 Find this comment inappropriate? Report it

Interesting Can you list other items which asset managers rely on from analyst except forecasting and tell your readers how do they fare on those items. Secondly you state that most investment houses do not put much weight on forecasting and I . .more suppose they put value on other research ouput from analysts. To reach a conclusion about the value added we will need to know how much weight is given to other research products and how often do Asset managers use info from analyst to take decisions or advice their clients!!! . .less by zozo on November 19 2009, 10:53 Find this comment inappropriate? Report it

Glorified Investment Clerks Thats what they are are.Worked with them at FEDAM, INVESTEC & STANLIB.The know zilch.It all comes down to contemporary knowledge and not professional qualifications acquired years ago. Investors should demand no entry fees . .more and no fees for negative performance. . .less by Zoro on November 19 2009, 15:22 Find this comment inappropriate? Report it

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