Anonymous analysts rule

MADELAINE DROHAN

GLOBE AND MAIL UPDATE

AUGUST 22, 2008 AT 6:36 AM EDT

OTTAWA — Media reports of corporate earnings these days are full of faceless analysts who seem to have the power to send the value of a company's shares plummeting or soaring, depending on whether their expectations have been met.

As someone who does not work in the stock market, I often find myself wondering: Who are these people and why should we care what they think?

For example, when Apple Inc. reported stellar results in July, with revenue up 43 per cent from the previous year and computer sales at a record high, news reports said the value of the company's shares fell because Apple's outlook for the future was not as rosy as that of “Wall Street analysts.” The reports I read did not identify these analysts, but clearly their disappointment packs a punch.

Another faceless crowd of analysts (or perhaps it was the same one?) were apparently delighted when Amazon.com Inc. reported higher profits than the analysts had expected in August. Shares in the company rose on the back of the analysts' approval.

Just about every report of a company's earnings makes reference to the expectations of analysts, without saying who they are, what their track record has been, and how many of them are behind the group forecast. Shouldn't that matter?

Sometimes readers are told that analysts were surveyed by a particular firm, such as Thomson Financial or Bloomberg. On the odd occasion, we are even told how many analysts were surveyed to produce what is called a consensus forecast. This turns out not to be a consensus at all, but rather an average of the forecasts of some of the analysts who follow a particular company. This then becomes the baseline for judging a company's performance.

There would seem to be significant problems with giving so much weight to something produced in this fashion.

Let's start with the number of analysts surveyed. Big companies may be followed by any number of people, and if you believe in the currently fashionable “wisdom of crowds” approach to information, averaging the guesses of a lot of analysts might produce something credible. Even then, predicting the future is a bit of a mug's game.

But smaller companies may only be covered by one analyst or none at all. If something billed as a consensus is really only the view of one or two people, no matter how expert they are, should it be taken seriously? Analysts, like journalists, vary enormously in quality. The companies issuing the consensus forecasts may make clear how many people were surveyed. If they do, it rarely comes through in the media reports.

This is not some hypothetical concern. The 2002 reforms in the U.S., which followed the market crash, reduced the number of companies covered by analysts as limits were put on the ways that firms could be paid for such research. There were definite benefits from the reforms. Estimates became more realistic and recommendations more honest. But the downside was that the number of companies receiving analyst scrutiny shrank.

In 2005, Reuters (now Thomson Reuters) and the Nasdaq Stock Market in the U.S. stepped into the breach, setting up a network to distribute independent research on the estimated 35 per cent of all public companies in the U.S. that had no analyst coverage. But the Independent Research Network shut down in2007, leaving many companies with little or no coverage.

Who the analysts are would seem to be an equally important piece of information. It sounds so ominous when a report says that a company has disappointed “analysts” or, even worse, “Wall Street” with its results. But the picture would change if you knew those “analysts” included someone whose last five predictions were well off the mark, or someone new to the area without any track record at all, or someone who used to work for the company they are now covering.

It would also be useful to know whether they represent a true cross section of analysts who watch a company, or just those employed by brokerage firms that manage accounts for clients. Their views, like their needs, may differ from analysts employed by investors who are in it for the long term, such as pension funds.

Many companies list on their websites the analysts who cover them, so it is theoretically possible to find out what each of them thinks and what their track record has been. But for your ordinary investor that would entail a great deal of research and possibly a lot of money.

Having analysts estimate a company's results is part of what's called the earnings guidance game. Companies play along. They routinely brief the analysts who follow their stock on what they think lies ahead. However, there are reports of companies deliberating low-balling future prospects so that they can surprise analysts when they exceed their expectations.

Games are fine as long as everyone plays by the same rules. But in this game it seems insiders have the advantage. That leaves ordinary shareholders and even some analysts sitting on the sidelines.