Security Analysis: Science or Art?
In 1934, McGraw-Hill published the first edition of Security Analysis, a 700-page text that was to become the bible of Wall Street research. This weighty tome, often referred to as Graham & Dodd, the authors, debuted as an analytical response to the stock market debacle of 1929- 1933. Replete with a plethora of evidence supporting the authors’ contention that there is indeed a cause-and-effect for movements in stock prices, the book set a standard for stock evaluation that has remained in place for decades.
When pondering the subject of security analysis, one of the key questions is whether a good company is also a good investment. There are more than a few good companies, but when recognition of these companies is widespread, valuations tend to get stretched, occasionally far beyond what might otherwise be considered defensible levels. So an ostensibly interesting situation may in fact turn out to be one that is supported by a Utopian thesis in which there is no room for disappointment. It would not be inappropriate to refer to this kind of example as a growth story on steroids. The inherent risk is that the shares would be priced for perfection and the slightest shortfall on fundamental issues could push the price over a cliff.
In cases where the inherent value of a company is not widely recognized, it may be undervalued. This is typically the case with smaller companies, though it also manifests itself with larger companies that may be in the process of beginning a new growth phase or working their way through a period of consolidation. The latter are often called turnaround situations, though the reality is that only a few are successful at climbing above their recent plateaus. The rest usually find themselves in a never-ending morass of problems that do not get resolved.
Though each situation encompasses different issues, it seems that unless one or more of the key variables changes, the net result will be disappointing. Usually, this means a new management team or a breakthrough product, either or both of which may refocus the corporate sights sufficiently to move ahead.
Analytical efforts to uncover good investments run a wide gamut. In the early years of security analysis, it was not uncommon to come across reports with dozens of pages. These days, far fewer trees need to be cut down to contain these kinds of ostensibly exhaustive outpourings.
One has to wonder whether such lengthy reports have more value than succinct, but to the point, one-page efforts. My sense is that as one gets deeper into the minutiae, the risk of missing the trees for the forest rises exponentially. After decades of reading more analyst reports than I could possibly remember, I find little basis for believing that the additional verbiage provides any greater advice for the reader.
Looking back at the 1970s, when a pair of oil embargoes wreaked havoc on the major American auto makers, analysts continued to crank out lengthy reports detailing the reasons for Detroit’s problems. The great mystery was not what was wrong with Detroit, but why they wasted so much paper answering the question. The issues were straightforward. The Big Three were making big, inefficient, poor quality cars that no one wanted anymore. The issue was what Detroit was going to do about it. That did not take dozens of pages to answer, but it did take dozens of years before domestic offerings met the challenge from abroad. While doing so, they lost their industry leadership and their stock prices plunged.
Securities analysts come in two main varieties: sell-side and buy-side. Sell-side analysts tend to have a lot to say since their efforts are explicitly aimed at selling the stocks that are the subjects of their reports. Not surprisingly, their compensation is directly related to the sales that result from these reports. Buy-side analysts have no ax to grind, so their reports tend to be less biased. Theoretically, recommendations could range from Buy to Sell, but the majority tend to be Buy, Hold or somewhere in-between. Now and then a Sell recommendation may come along, but that’s a rarity on Wall Street, which spends an excessive amount of time on the first part of the equation and overlooks the fact that one needs to sell to capture a hoped-for gain or give in to the reality that the situation did not work out.
tend to be lemmings. When conjuring up earnings estimates, there is no special
skill required to find out what the consensus is for any specific company. Some
may be slightly higher or lower, but few will be willing to post numbers that
are skewed far from the mean even though there may be compelling arguments for
doing exactly that. The reason is largely financial. Analysts who use the
consensus number as their own mitigate their personal risk by doing so. If the
consensus number is wrong, they are shielded by the fact that the other guys
made the same mistake. If, on the other hand, their skewed number is wrong while
the consensus number is right, their compensation may suffer and their jobs may
be in jeopardy.
The matter of earnings estimates is a curious one. In the early days, the best an analyst could hope for was to prepare his worksheets based on projections of revenues, profit margins, and taxes, and postulate a net income figure for his corporate contact to reflect and perhaps comment on. More recently, companies have adopted policies of issuing earnings guidance, often put forth in prospective ranges. Analysts obsess on these kinds of utterances, parsing the intonations with a goal of determining whether the guidance brings with it overtones that match or exceed the corporate enthusiasm of prior revelations. The objective is to figure out from the nuances how much better a company is likely to do relative to how well it had stated it will do. So if the actual number for a prior quarter was five percent better than the guidance, it is now essential to figure out whether the same or better rate of surprise is on the way.
This kind of voodoo has led to the whisper number. That is the number the Street is looking for, which one assumes is a number that is whispered by the cognoscenti. There is usually no problem if a company matches its whisper number, but if it merely meets its guidance or falls short of the whisper number that could add up to a bad day of trading. Or, if it hits the whisper number, but any of the accompanying verbiage suggests that there are potential trouble spots, that’s bad news, too. The hitch here is the overemphasis on the here and now.
As the mass of information available to investors has grown, the major challenge now is sifting through and focusing on the factors that really matter. Back in the 1960s, the world of security analysis was quite different. In those days, corporate operations were far less transparent and there were fewer analysts. Analysts who did a reasonably worthwhile job of assimilating data and making projections could, on occasion, have worthwhile conversations with company contacts and hope, with astute questioning, to get answers pointing in a helpful direction. That was not always a fruitful exercise. For one thing, unlike today, not every company had a designated contact for analysts and some companies would not speak with analysts. For another, there were spokesmen who would agree to an interview without offering any information that was not already contained in a public announcement. For a long time, we have taken for granted the quarterly pattern of corporate earnings releases, but back then there were companies with a nearly nonexistent flow of information.
Perhaps there was a time when certain information was available to more plugged-in analysts, but not to others. As stricter regulations came along requiring general dissemination of material corporate developments, everyone involved, both within the Wall Street community and within the universe of investors, ended up on a level playing field. The same information was available to all; the difference was how one evaluated it.
Analyst meetings come in numerous different flavors. The most lavish are squarely aimed at garnering favor. Those that are more barebones suggest that management is more concerned with running their company than hosting analyst events.
Of all the meetings I attended as an analyst, the most memorable was a multiday boondoggle in Puerto Rico. Upon arrival, we were rushed from the airport to our hotel to be sure that we would be in time for a tennis round robin that was to serve as the kickoff for the conference. Over each of the days following, we had morning sessions followed by afternoon activities.
One that stood out took place aboard a yacht chartered by the company’s chairman who happened to be vacationing in the area. We analysts were taken from our hotel to the eastern end of the island, where we met the yacht and had a fair share of liquid refreshment. We then jumped into the water and interviewed members of the management team . . . in the water. The memory of that meeting is far more pleasant than an earlier experience where I and a few other analysts spent most of a two-day trip shuttling aboard a corporate jet from one plant to another, including one with considerable asbestos exposure.The most embarrassing of my field trips was a conference held by Dana Corporation in Toledo, Ohio. It was a big conference, attended by dozens of analysts. Most of the time was spent in lecture halls where we were addressed by key personnel. As we were wrapping up one of the morning sessions, I got up to go to lunch and realized that the backs of my legs were unusually cold. When I reached down to find out what happened, I noticed that my pants had split right down the middle and I was fully air-conditioned. A short panic ensued while I passed an urgent request for help to my contact at Dana, who was kind enough to escort me to a shop in downtown Toledo where I was able to find a replacement for my damaged clothing.
Far more frequent than field trips were luncheons in downtown Manhattan, usually held at the Bankers Club, the City Midday Club or later on at Windows on the World, the restaurant atop the World Trade Center. They were welcome respites from the hours spent reading, calculating, and attempting to come up with interesting conclusions. With rare exception, the bill of fare for most of us was what was lovingly referred to as rubber chicken. Still, there was one analyst (viewed by some as a Wall Street guru) who would loudly command the service personnel to bring him a steak. Draw your own conclusions about his ego.There were a few company contacts who would schedule quarterly one-on-one lunches and did, in fact, spend most of the time reviewing the latest developments. At no time, however, did any company contact ever provide information that was not already available to the general public. Indeed, in the rare instances where I had heard of information that had inadvertently slipped out, the companies in question always followed up quickly with press releases to ensure that the regulators did not charge them with evil-doing.
Bottom line: In the short term, it’s anybody guess what the markets will do, but as time extends improving business fundamentals will lead to higher prices.
N. Russell Wayne, CFP