Wall Street analysts still hyping their stock picks

Wall Street analysts are painting an awfully rosy picture of earnings growth, according to a study done by Penn State researchers. “[T]heir long-term earnings-per-share growth-rate forecasts are excessive and upwardly biased,” says J. Randall Woolridge, a professor of finance at the Smeal College of Business.

Over the period 1984 to 2006, analysts’ predicted EPS growth at an average of 14.7% for the long term (three to five years). Actual EPS growth: 9.1%.

On one-year forecasts, analyst projections fared a little better, but they were still overly optimistic: 13.8% instead of the actual rate of 9.8%.

So why is this happening?

  • Analysts’ employers want them to hype stocks so the brokerage can win commissions and underwriting deals. “This conflict of interest should have been squelched by former New York Attorney General Elliot Spitzer’s investigation and the $1.5 billion payment made by U.S. investment firms in the 2003 Global Analysts Research Settlements (GARS).” But the study found that GARS had no effect; analyst forecasts remained at their historic levels of about 15%.
  • Analysts don’t issue forecasts on stocks they don’t like.
  • Analysts becoming attached to the companies that they follow and, as a result, lose objectivity.

Most companies fail at forecasting earnings
The fallacy — and cost — of giving quarterly earnings guidance

In praise of organic growth vs. financial engineering

Research shows that mergers & acquisitions don’t produce the expected financial bonanza. But “organic growth” does.

The Batten Institute, part of the University of Virginia’s Darden School of Business, has released the latest results of a decade-long study of corporate earnings, establishing a correlation between organic growth and outperforming stocks. Using an Organic Growth Index (OGI), Darden professor Ed Hess compiled a list of “Organic Growth All-Stars” for the period 2003-2006. The conclusions:

In addition to consistent growth in underlying earnings, as measured by the OGI, the all-star companies’ share prices have outperformed the S&P 500 by a factor of 10 over the past 10 years.

Actual 10-year returns (1996-2006) for the OGI All-Stars were over 1,368% vs. approximately 130% for the S&P 500 Index and 144% for the Dow Jones Industrial Average.

“These companies have shown that they can grow in good times and bad. It’s not about the economic cycle. It’s about the business model,” Hess says. “Organic growth is growth the old-fashioned way: more customers, more products, better operating efficiencies,” he says. Not financial engineering or manipulation.

Hess identifies four key attributes of strong organic-growth companies:

  • Simple, focused business strategies, implemented by managers who are are “execution champions”;
  • Top management is home-grown and made up of “humble, passionate operators”;
  • A highly-engaged workforce characterized by a strong degree of loyalty and productivity; and
  • A “seamless, self-reinforcing internal growth system”

The study — and the list of 27 All-Stars — is available at this link. For some reason, the all-star list includes a couple of “dollar stores,” a couple of casual restaurant chains, a couple of big-box retailers, and the maker of Spam.

Most companies fail at forecasting earnings

Two out of every three companies are unable to accurately forecast earnings for the next quarter, missing the mark by anywhere from 6% to over 30%, according to a study of 70 multinational companies by The Hackett Group.

We’ve all seen cases where missed earnings projections led to sharp stock declines, CFO firings, or worse. But often companies don’t take the steps necessary to get better at forecasting, Hackett analysts say.

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The fallacy — and cost — of giving quarterly earnings guidance

Many executives believe that the quarterly game of giving Wall Street “earnings guidance” provides various benefits: visibility, reduced stock volatility, better valuations. But thorough research by McKinsey & Co. indicates that the practice doesn’t actually work — there’s no evidence that it produces the expected benefits — but carries its own costs.

The two costs:

  • It takes up valuable management time to prepare the guidance reports (i.e., it’s a distraction).
  • The practice produces too much emphasis on short-term performance.

In my opinion, that short-term mindset gets in the way of long-term strategic thinking and thwarts important investments in areas such as innovation, human capital, environmental sustainability, safety, and competitive intelligence. This short-term mentality — called “short-termism” — could be the No.1 problem in American business.

Oh, and McKinsey’s researchers found that, when some companies stopped providing the quarterly guidance, there were no dire consequences.

Continue reading “The fallacy — and cost — of giving quarterly earnings guidance”