Can you trust Wall Street’s numbers?

Market Advice

Can you trust Wall Street’s numbers?

We’ve all heard of profit warnings and earnings surprises. With companies updating investors every 3 months, it’s almost shocking that anything radical happens. Yet, every day a company surprises the professionals on Wall Street, and they find themselves adjusting their forecasts.

So can you trust Wall Street’s forecasts? Or are they no better than a stab in the dark. Is it all financial voodoo?

The french writer, Jean-Paul Kauffmann skewered finance with:

The economy depends about as much on economists as the weather does on weather forecasters.

He’s right. As voyeurs, financial professionals are like meteorologists. They have no influence on the outcome, and their forecasts prove to be unreliable. It’s hardly surprising, given how complex the world is. And still we check the weather!

If you ask Wall Street, they love pretty much everything. They’d recommend you buy 65% of stocks they cover, keep holding on to 30% of the ones you’ve already got, and only dumping 1 in 50 stocks.

Similarly, Wall Street loves forecasting where a stock price could be within 12 months, or target price, as they call it. Again, it’s hard to find anything they really don’t like. With 1% of stocks forecast to decline over 25% and another 15% forecast to decline up to 25%. In contrast, they expect 60% of stocks to increase more than 10%. That correlates nicely to their Buy/Strong Buy recommendations.

So if everything is a “Buy” or “Hold” and Wall Street produce 12 month price targets suggesting there is a profit in 7 out of 8 stocks, then you might conclude their advice lacks credibility. As Jim Chanos points out:

Brokers aren’t interested in the truth or what’s best for the client, but in making the sale with the least amount of work.

So don’t go hanging on the every word of a Wall Street analyst, wondering if they might upgrade a stock to Buy or increase their price target!

Using Wall Street …

Despite their failings, there is value in looking at the views of Wall Street. Though it’s not immediately obvious to most.

Buffett’s mentor, Ben Graham said:

Analysis should be penetrating not prophetic.

So, for all its flaws, don’t discount Wall Street. The professional analysts spend all day looking at a stock and its competitors.

Bar the management team of a company, virtually no one understands the drivers of the business better than the Wall Street analysts do.

As a result, their views on the revenues, profitability, cash-flow and future growth are the best guides we have.

But, like anyone who lives and breathes these numbers daily, they often become too involved to see the big picture. They succumb to the charm of the CEO, who they know personally. They don’t like being wrong, and defend their positive view, even as the evidence mounts against them. In essence they are human too.

Remember, there are only two drivers of a stock price, both short and long-term:

1) Fundamentals

2) Sentiment.

  1. Wall Street analysts forecast the entire financial profile of a business. Their aim is to understand the cash-flow potential. A change in the fundamentals will change the cash-flow potential, which changes the value. Therefore the change in Wall Street’s views on a stock’s fundamentals are as important as the actual forecast itself.
  2. Just like fundamentals, both the absolute sentiment and the change in sentiment are key. What is the absolute valuation of the stock? How does that compare to its peers? To alternative sectors or assets? Wall Street are pretty good at understanding the sentiment for their narrow universe. But does an analyst who covers tech stocks have any idea on the sentiment of the market relative to oil stocks? Sadly, rarely.

… to understand the crowd

Buffett’s mentor, Ben Graham used to obsess about Mr. Market. For most of us, the views of Wall Street professionals are the closest we’ll get to understanding the view of the crowd.

So how should we all use Wall Street’s numbers? Look at the fundamentals and sentiment. Think of the absolute levels of both. Think of the relative strengths of the business and relative valuations. Think about recent changes in both the fundamentals and sentiment. And then decided, do you agree? With what level of confidence?

As John Templeton said:

If you want to have a better performance than the crowd, you must do things differently from the crowd.

Though don’t feel obliged. You can always choose to just follow the crowd, as passive investing, via Vanguard and ETFs. It is an excellent alternative to actively managing your portfolio.

Author notes:

Shane Leonard, CFA, is the CEO and co-founder of Stockflare. Previously he worked as a stockbroker at Citigroup and Credit Suisse. The views in this article reflect his personal views!