Analyzing The Analysts

by: Braun Research

It appears that discussing the behavior of analysts is becoming a fashionable trend. And not a moment too soon, considering the important role these market participants have, both in their sell-side and buy-side incarnations. An article by Mark Bradshaw of Boston College under the title "Analysts' Forecasts: What Do We Know After Decades Of Work?" (see here) is quite thorough in reviewing the role and the modus operandi of mainly the sell-side analysts. But from a practical point of view, he tends to lay out directions to be followed by future academic research rather than offer solutions that could help in investing Here and Now.

However, a rather usable way to analyze these market-moving players' activity does exist; and with excellent, provable results. Right now, this approach has been bullish for the last 3 years, in the face of derision and contempt by much of the establishment which, over this period, was dominated by "bears" concerned with the possibility of (1) a double-dip recession, (2) a further steep decline in the U.S. housing prices and (3) with Greek contagion in America, none of which was going to happen as gleaned from our well founded view of the analyst community's psychology and behavior. So what is this view?

The system, let us call it CAP for Capital Appreciation Portfolio, takes a rather unique approach in its use of consensus sales and earnings forecasts, as well as an estimates-change factor (not revisions!), as reflected in both sell-side and buy-side analysts' behavior. It is essentially an effort to detect stocks that are more likely to be up-graded than down-graded by the analysts in the next several weeks/months. The method attempts to determine timely entry points for worthwhile buy candidates. It can be thought of as a "downgrade-risk" control method, a type of risk not mentioned anywhere in the academic literature to my knowledge, but well worth quantifying and taking into consideration given the drastic effect on the stock prices that upgrades and downgrades by sell-side analysts can have. The buy-side analysts impact the price by their very actions of buying or selling the stocks.

The stocks selected are in fact stocks that the sell-side (Wall Street) as well as the buy-side (users of HOLT, AFG, and other DCF methods) "do not like… but will." Ultimately, the process forecasts the behavior of the entire analyst community as opposed to the well known Khanemann-Twersky behavioral finance approach which looks, very creatively I believe, at the behavior of the average investor rather than analyzing the analysts who are an immensely important force in determining the prices in the market. Mr. Khanemann and Mr. Twersky were honored with a well deserved Nobel prize in economics. No such ambitions here; just trying to develop a way to better invest, that's all. The selected stocks do not represent of course a fully defined investment approach but are rather a-pond-to-fish-in, meant primarily for by professionals. They require some kind of an overlay in order to determine the actual stocks to be eventually bought.

Just to prove the value of this approach, for demo-of-concept purposes we applied a clean, solid and somewhat run-of-the-mill DCF analysis overlay (not genius-level on purpose, as we were looking to mimic the behavior of the average analyst) and created CAP, which invested for the past 11 ½ years a relatively small amount of the founder's own money, to prove that this unique approach for finding timely entry points is well worth paying for by professional PMs and Analysts. The results of CAP, which is long only with no leverage and no change of strategy, are quite attractive - we believe - at a 6.6% alpha (11 ½ years average annual return over the S&P500 as represented by the SPY ETF), with a beta of 0.9, after all fees and brokerage costs. For a discussion of how much or how little that alpha is really worth as well as a more in-depth analysis of the portfolio's performance as compared with Berkshire Hathaway's portfolio (NYSE:BRK.A) as an example, you may want to take a look at an earlier article I wrote titled "Alpha, Beta, Risk And Performance Measurement … Again" (see here). The approach is scalable without loss of performance - again as we believe - to at least $1.5-2 Bil. and the performance might even be improved somewhat by using a less expensive trading approach, not available for smaller amounts.

So what does the system recommend right now? On April 3, and a few days before, the portfolio manager bought a rather eclectic looking group of stocks:

  • American Capital (NASDAQ:ACAS) is the first Financial Sector stock bought in 5 years. It plays to the housing recovery.
  • Genpact (NYSE:G) is in the supply chain management business, really a Technology company, classified nevertheless as an Industrial.
  • Verisk Analytics (NASDAQ:VRSK) is doing risk analysis for businesses, among others for insurance companies. We are a little late on this one but the analysis indicates that there is enough upside left in this stock classified as an Industrial (it is really a software company).
  • Syntel Technology (NASDAQ:SYNT) provides IT services and is classified as a Technology stock.
  • Questcor Pharma (QCOR) is a Healthcare-biotech company, already a rocket but still worth buying.
  • Nordson (NASDAQ:NDSN) makes specialized components for the aerospace and is classified as an Industrial.
  • CTC Media (NASDAQ:CTCM) is a Russian provider of broadcasting and TV services. In many ways it is, believe it or not, a Warren Buffett-style company but it is a much riskier bet than what the Sage from Omaha would buy. It nevertheless cleared our discipline and we bought it because, unlike Warren, if it stumbles we will have no reservations about selling it promptly.

All stocks are typically held about 2 years.

As you may have noticed, the stocks selected tend to be issued by mid- and smaller-cap firms with a good cash flow over the invested capital, low new capital requirements, high beta (which some call "risk" but in the current environment we call "reward"). These are all appropriate characteristics for the market we are in right now and much different from the large-cap, export-oriented stocks that we were buying 2-3 years ago. Did the PM buy them simply because they qualified on the quantitative analysis? No way! A "human" review, more extensive than the bullets cited above would betray, indicated that these firms also had an excellent chance to be rewarded in the next few years on their fundamentals and, most important in the current phase, they do not have too many "hopes" attached to them. After the "fear" period of the past three years, where the market was climbing the proverbial "wall of worries" and before the market hits - maybe in a year or two or more - the "greed" phase, we see a market running now on "hope," meaning that any stock which is big in the news, i.e. has tremendous hopes attached to it, will be punished more mercilessly than usual for the slightest stumble. That's not the case either in the fear or in the greed stages. As discussed in an earlier article on Seeking Alpha, Industrials are not dead… yet. Four Industrial stocks were sold by this same manager last month but, lo and behold, three more "Industrials" made their way into the buy list here. Two of them are not really Industrials but the GIC classifications are what they are. What's important is that there are no pre-conceived ideas, just good old solid analysis. Is this a stock-picker's market or what?

Part II will look at the strategic and sector allocation aspects of the CAP portfolio.

Disclosure: Long ACAS, CTCM, G, NDSN, QCOR, SYNT, VRSK.