Win By Not Losing by Nick Atkeson

Author:Nick Atkeson
Language: eng
Format: epub
Publisher: McGraw-Hill Education
Published: 2014-12-18T05:00:00+00:00

a. The Sell-Side Analyst Conundrum and How Earnings Momentum Can Be Predictable

Rational people with high-paying jobs usually want to keep their jobs. If the job is to predict the future, analysts are far more likely to keep their jobs in the short run if they predict the average of what everyone else is predicting rather than stepping out on a limb and diverging from the consensus by a significant amount. If the prediction is in line with consensus expectations and the analysts are wrong, they are wrong along with everyone else. If the prediction is far from the mean and an analyst is wrong, he or she must be deficient since everyone else knew the answer.

Investment banks pay their senior analysts well. The job is prestigious, and analysts are considered experts. Analysts are eager to keep their jobs and as a result are usually hesitant to make predictions that stray from the conventional view. If they do have a differentiated viewpoint, it is often expressed only in verbal comments to their best clients rather than written in their formal research reports.

When a company reports meaningfully better than expected earnings and revenues, analysts will perform their checks with management and the broader industry. If a secular change is under way, analysts may adjust their forward estimates only modestly higher as they want to make sure a new trend is under way and would rather not diverge too far from the mean estimate. As several more earnings cycles pass, analysts frequently and with chronic persistence underestimate actual earnings. Over time, the sell-side investment analyst community becomes less relevant to the investment process as mutual fund and hedge fund money managers are willing to jump on board the better earnings reports faster than do sell-side equity analysts.

The cycle of exceeding analysts’ estimates is often predictable in light of the pressures on analysts to be overly conservative. Stocks that consistently beat estimates often become momentum stocks that demonstrate considerably better performance than the average stock during their outperformance cycle. This dynamic helps explain why there is a large group of institutional stock buyers focused on momentum or high relative strength stocks.

Just as predictably as stocks rise on repeated better-than-expected earnings, they fall sharply when they miss the estimates. Often they miss consensus earnings estimates after a long winning streak more because the analysts become overly aggressive in raising estimates than because of a fundamental change in the company’s operations.

While the company is beating earnings steadily, a conservative sell-side analyst becomes a less important part of the investment process for the institutional buy-side customer. To get back into the game, a sell-side analyst may jump out ahead of the pack with an aggressive forecast. If the forecast is right, this analyst is now the go-to guy on the stock and has regained his or her position as an important part of the institutional investment process.

Other analysts now follow with equally aggressive if not more aggressive estimates. As expectations ratchet well above what may be thought

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