Is Reading Financial Analysis Dangerous?

This article discussing the dangers of most financial analysis was written y Evan Bleker. Evan is a private investor and founder of Broken Leg Investing & Net Net Hunter.

Spend a lot of time on financial media sites reading financial analysis?

Looking for investment insights from pros to know which companies to invest in?

Maybe it’s time you quit that habit.

If you’re like most people intent on picking their own stocks you’re putting in a lot of time and effort reading through investment analysis to help identify great investments. Unfortunately for you, a lot of this research is complete garbage, nonsense.

Not only does most financial analysis fail to help you as an investor, it can destroy a lot of the wealth you’ve spent time putting together.

Is Reading Financial Analysis Dangerous?

Dangerous might be a bit of an exaggeration but investors put a lot of stock into professional financial analysis. It’s widely believed that financial analysts have the skills, the insight, the resources, and the access needed to understand a company’s situation and direction.

All of these assumptions mean that an investor is likely to put a lot of emphasis on the assessments of pros and this often translates into buying and selling based on their recommendations.

This would be fine if analysts followed sound investment principles but investors expect to be told what to buy and are often looking for quick price action on a stock. As a consequence, the industry tends to dish up this type of half-baked analysis.

Betting on short term capital gains is the opposite of sound investing, but this strategy is only encouraged by the comments and actions of professional analysts. If the truth about analyst reports was more widely known, investors would think a lot differently about how to find good investments and their own investing.

A Troubling Tell-All Tale

Last week one of our subscribers to The Broken Leg Investment Letter forwarded an interesting email he got from an investment site. I don’t normally read articles in the financial press but this one caught my eye.

The article was written by Kim Iskyan, a former stock analyst and broker based out of Singapore. What made the article so fascinating was Iskyan’s tell-all expose of the world of professional analysts. In a word, it was shocking.

What exactly was in it?

Iskyan discussed 5 dirty little secrets that analysts don’t want you to know, and I’m making those available to you here:

1. You Can’t Trust The Word “Buy” If You Find It In A Published Financial Analysis

It’s common knowledge that analyst reports are broken up into buy, sell, and hold ratings which are then used to provide investment recommendations. In a perfect world, this would provide their readers with a lot of value. In a perfect world a well trained and experienced analyst would take an objective view of the company, after a tremendous amount of research, and sum all of it up with a simple buy, hold, or sell recommendation. Investors would get the advice they’re relying on, make well-placed investments, and everybody would dance in the street.

In reality, Iskyan says, “70 percent of the stocks with an analyst rating in Asia were rated a “buy” by at least half the analysts that were covering them.”

That’s a very large number of buys in a discipline that’s supposed to use business prowess to screen for the best investment candidates. Why so many buys?

Iskyan continues, “Stock analysts have a lot of reasons to call a stock a “buy.” They might want to cozy up to management, to try to get banking business from the company, to generate commissions for their employer... or maybe they don’t want to stand out from the crowd of analysts who are saying a stock is a “buy.” “

This revelation alone should be enough to erode your trust in stock analysts.

2. Analysts Just Guess When Putting Together Their Financial Analysis

Part of the job of an analyst is providing solid estimates and predictions for revenue and profit a quarter or year down the road.

But, a business is a complex thing. There’s a whirlwind of human activity within a company and all sorts of incentives and business processes at play. There’s also the environment the company operates in (it’s market, its competition, its regulatory environment, its access to resources, its interest rate environment, not to mention global macro economics) and how that environment interacts with the business.

When looking at all of the company’s stakeholders, analysts don’t have a tremendous amount of insight. Sure, they can take a bird’s eye view of the firm, but they can’t know its operations as well as the company’s own employees and even employees only ever have a rough understanding of what’s going on. As Iskyan writes, 

“…only a few people at the company have a real understanding of what’s really happening. Everyone else? They don’t know enough to predict... it’s nothing more than a guess.”

Not at all comforting if this guesswork factors into your portfolio.

3. Analysts Are Parrots -- Their Financial Analysis Is Not Helpful

When analysts don’t guess, they copy.

Given the complex estimates that have to be made, it makes sense to get the estimates and projects from those who know best: management.

“Senior management at companies are often among the few people who really do know what’s going on at the company,” Iskyan writes. “So when stock market analysts speak with the head people at a company, they often take their word as gospel. It’s a bad idea to lie, but of course a CEO is going to put his own company in the best possible light.”

What CEO wants to suggest that his company won’t do better in the future? Only the CEO who least likes his job. Edward Lampert, for example, provided nearly a decade’s worth of “things are getting better” talk while Sears slowly died. The only difference is that he could have told investors the truth since he was majority shareholder so his job was secure.

This excess positivity makes its way into investor portfolios as well. Unfortunately for them, reality hits when the stock price tanks.

4. Price Targets Are A Joke When Included In Financial Analysis

If analysts guess where the company is heading and what it’s going to earn, how are they supposed to get price projections correct?

The price of a stock is only roughly correlated with the company’s performance. There are a lot of other factors that come into play, such as interest rates, geopolitical events, and investor sentiment. To have any confidence at all in a price target, the analyst has to be correct about all of these other factors as well.

In reality, though, price targets are arrived at much differently. As Iskyan writes,

“…an analyst with an earnings model (usually a hopelessly complicated, sprawling Excel spreadsheet) can tweak a few figures and assumptions to produce a price target that is whatever he wants it to be. “

Unfortunately for investors, these price targets also act as price anchors, making rational objective investing much more difficult.

5. Most Writing Financial Analysis Don’t Eat Their Own Cooking

Warren Buffett likes companies that have management that own shares in the company they manage. This makes sense. You want to invest alongside people who have a significant personal stake in the company so their interests are aligned with yours.

Analysts can own shares in the companies they write about, but this is not always the case. As Iskyan ends off, “They may invest their own money. But unless they work for an asset management company, it’s rare for stock analysts …to actually manage money.”

How You Should Manage Your Own Money

So, if taking the advice and recommendations of analysts is out, how should you go about putting your money to work?

Should you just put your money into mutual funds?

It’s no secret these days that mutual funds drastically underperform the market averages over the long run. Not only that, you also get the privilege of paying your fund manager to underperform. 

An obvious solution most people consider is to by an index fund. This is what John Bogle of the Vanguard Group recommends, and it’s simple to execute. If you’re interested in passive investing, pick up Bogle’s “Little Book of Common Sense Investing”. If done well, you could net an 8 or 9% annual return over the course of your life.

But index investing today is likely to lead passive investors to ruin -- you are not likely to earn 8% long term. Instead, you're likely to lose a lot of money. But, even if index investing today were a viable strategy, what about those investors who are looking for something a little higher than 8%? Are they completely out of luck?

Not really.

The key is to focus on finding a solid investment strategy.

When I first sought out to find an investment strategy that I could use to beat the market, I had a couple thoughts in mind. The first was to look for a strategy that was shown to work well in academic studies over a long period of time - the longer the better. This meant trying to find one that had worked over decades, not just the past few years.

The degree of outperformance was important. Knowing that people make mistakes and have all sorts of behavioural biases, it wasn’t enough to find a strategy that outperformed by only a few percentage points per year. Those few percentages points would likely get eaten away by mistakes that I would inevitably make. I needed something that had large outperformance.

Lastly, I also wanted a strategy that was easy to use, such as Graham's Simple Way or Ultra stocks, and had been proven to work in practice. It’s one thing to see a great strategy on paper, it’s another to be able to use it in real life.

This criteria lead me to value investing, originally made famous by Warren Buffett’s teacher, Ben Graham . I've chosen to invest in Graham's famous net net stocks but there are other fantastic high performance value strategies open to fit every investor. Four of those strategies are Simple Way 2.0 stocks, Ultra Low Price to Net Tangible Assets stocks, Acquirer's Multiple stocks, and Pay Daddy net nets. After more than a decade of experience, I now have the privilege of teaching other keen investors how to put that strategy into practice. Click here for insight into the highest performing deep value strategies.

Investing isn’t rocket science. It’s not brain surgery, either. It does take more thought and effort than just plowing your money into a few stocks with good analyst reports, however.

Few people are truly on your side in the world of investing so you have to find a solid strategy by trusting the data and making rational decisions. That’s what I did and the results have been great.

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