Can You Find Analysis That Cuts To The Heart Of The Issue?

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Includes: CMG, JACK, MCD, TGT, WEN, WMT
by: Colorado Wealth Management Fund

Summary

If investors want to assess whether analysts are lucky or good, they should look beyond the binary buy/sell ratings.

A strong analyst should be able to predict the story leading to the returns.

For instance, an analyst that successfully predicts a change in store traffic, earnings, and free cash flows leading into a change in share price deserves more credit.

If you see a great piece of individual research, bookmark it and check back on it in several months to a year to see if the predictions were accurate.

Investors are always looking for ways to find better opportunities, and one of the ways is to find the analysts that understand how to spot alpha. However, there are some major challenges in finding the best analysts. How is anyone supposed to browse through potentially hundreds of analysts to figure out which ones are going to be right? Some sites attempted to solve the problem by automatically tracking analyst ratings. The idea sounds good, but in practice it just isn't viable to have a machine attempting to read every rating. It might work if all analysts would agree to tag their articles with metrics such as #Buy-Ticker.

Even then, for cases with a smaller sample size) how would the investor figure out who was delivering and who was merely lucky? The best way I've found is to look for far more than a simple buy, hold, or sell rating. Buy and sell ratings are very indicative of the choices the investor needs to make, but they are too binary. An analyst who hits 10 ratings in a row looks good, but luck can still overwhelm the results.

What I Like To See

Strong analysis tells a story before the market knows it. For instance, an analyst that correctly predicts mergers and the approximate impact on price is doing a great job. However, there aren't enough mergers to get a great sample size. So what else would work?

An analyst who can correctly predict several steps in sequence deserves to stand out. For instance, if the analyst said:

"McDonald's (NYSE:MCD) will see rising same store sales that leads to beating estimates on earnings and a significant growth in free cash flows as they divest physical stores."

Then the investor can assess whether each part of the story played out as expected. If the analyst was capable of predicting the entire chain of events, they did a much better job. The next question is how the stock compares to the rest of the sector. If the analyst covers the rest of the restaurant sector, are they comfortable predicting whether MCD should outperform Wendy's (NYSE:WEN) or Jack in the Box (NASDAQ:JACK)?

For the individual investor's return on a position in MCD, the only thing that would matter is the dividend and the change in share price. However, if the investor wants to know whether the analysis they were using was really on the money, they want to see if those factors played out. If MCD went higher based on a correlation to bonds despite weak same store sales, declining earnings, and a plan to open more corporate stores (instead of moving further into franchising), the "buy" rating might have been correct but the analyst would've missed the real story.

If similar restaurant stocks significantly outperformed and the performance was driven by expected changes in regulation for the industry, the buy rating was correct but the analysis was not.

When You Find a Great Piece of Work

If you find an article on a stock that appears to be an incredible piece of research, bookmark it. Whether you invest in the stock or not, come back in 8 to 12 months and check the predictions against the events. To be fair to the analyst, check for other work by the analyst on the same stock to see if they updated their stance. Did the rating change? Did the narrative change?

The analyst might even have a follow up piece where they gather the data after the company announced it so they can compare it to their estimates.

If the analyst was bullish on Chipotle (NYSE:CMG) and everything played out as predicted up until another outbreak, then the analyst may deserve some credit even if shares declined significantly. Over a large sample size, these low probability events should become less of a factor.

Dividend Advantage

One of the reasons for investors to prefer stocks that pay dividends is it creates an alternative way for the investor to get their returns. If the investor is precisely right about the fundamental strength of the business, the dividend should be solid and provide a meaningful return even if the market is slow to change the perception of the company.

My Approach

My major area for research is the mortgage REIT sector, so I use discounts to book value as a major part of the analysis. The strength of using discounts to book value as a major piece is that it gives investors the opportunity to profit from the discount moving back to what might be considered a "normal" range. The weakness is that a major change in the interest rate environment could dramatically reduce book value. When that happens, I want to update my views quickly. For instance, if book value falls from $10 to $9 and the price remains flat at $8, the stock may warrant a downgrade even though the price didn't move.

With other companies such as Wal-Mart (NYSE:WMT) and Target (NYSE:TGT), I may use alternative metrics such as EV/EBITDA. That means enterprise value divided by earnings before interest, taxes, depreciation, and amortization. I often favor EV/EBITDA in those scenarios because it reduces the impact of a change in the capital structure. For instance, the P/E ratio can be influenced materially by taking out cheap debt to retire shares. That may be a good financial decisions, but I don't want to dramatically alter my estimate of fair value based on a company changing their financial structure.

Conclusion

Whichever analysts you choose to follow, look for more than just the buy or sell ratings. Movements across the entire market or across the sector can cause specific stocks to show up as winners or losers. Knowing whether the analyst was able to predict the rest of the story correctly gives the investor a much better insight into the accuracy of their work.

The Mortgage REIT Forum is the most effective way for me to get my research to investors immediately. If your resolution is to understand your investments better, you should at least check out the reviews from my subscribers. The Mortgage REIT Forum averages 3 articles per week. One provides updated book value estimates for several mortgage REITs and includes my ratings (adjusted each week). The second article rates the different preferred shares and shows investors which ones are offering the best bargains. The third is used to highlight individual stocks and market failures or to provide a sneak preview on the articles I'm planning to publish over the next couple weeks.

Disclosure: I am/we are long WMT, TGT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.