Over the course of the Olam saga, I called several sell-side analysts to ask about their opinions. Almost all of them initially were very supportive of Olam. When I quizzed them over the negative Free Cashflow over the last 5 years, most echoed what Olam's management told the press, "you don't understand the business model". After the announcement of the 8% YTM 5 year USD bond, stapled with at-the-money warrants, some analysts started to issue "SELL" calls or "HOLD". Their reasoning was the dilution of equities destroys shareholder value. Many of the analysts could not cross the bridge between bonds and equities, that the issuer's bonds actually foretells where the equity prices will head to. If bond prices of Olam rose for short term debt, e.g. 2013 maturities, but continue to fall for the longer tenor ones, e.g. 2017 and beyond, it is a signal by the institutional investors that they are more comfortable with the short term solvency of the company but uncomfortable with the longer term prospects. Also, equity analysts fail to understand that when yields of an issuer rise beyond 7 - 8%, they signal heightened bankruptcy risk. If yields start to fall, that's when you should be issuing strong BUY calls immediately and start buying the equities.
It is very difficult for sell-side analysts to issue SELL recommendations on listed companies. No management of listed company likes to have a SELL recommendation slapped upon them for it often means higher cost of issuing capital. It may also mean a margin call on significant shareholders' stake if their shares are pledged. Also, brokerages often need to maintain good relations with listed companies as there may be potential placement shares and M&A businesses.
Below is an article in Seeking Alpha on why analysts downgrade Apple shares only AFTER the share price has fallen. Ring a bell?
Apple (AAPL) share price has tanked 20% over the last 6 weeks. First Call rating consensus shows a peak in optimism to 1.76 over September on a scale of 1.00 to 5.00, where 1.00 is 100% Strong Buy. Despite the 20% correction, the rating has declined to 1.83. The analyst consensus is a lagging indicator of the share price. Analysts get more bearish at lower prices: buy high, sell low. While the Apple share upswing lasted, target prices had good prediction power on a 1 month horizon, but were still poor on a 12 month horizon. Apple had missed estimates in its June quarter and negative articles were popping up. Until December, most analysts kept the mantra of raising target prices. I give some reasons why I believe analysts missed the reversal completely. My specialist sales experience at the Credit Suisse First Boston Technology Group puts me in a privileged position. This observation is a generalization that explains the average error of judgment. This does not exclude the possibility that some brokers actually deliver good homework and hire competent specialists.
Regulation has backfired
The rules on analysts' recommendations tightened after the 2001 crash. The regulation wanted to improve the transparency for all players on the market. Company financial updates and rating changes should be visible simultaneously to all classes of investors alike. Information now travels at the speed of light. Trading programs pick up these mood changes and act in nanoseconds. The Investment bank has no time to inform its fee-paying clients about changes in recommendation. Changing a recommendation has also become more cumbersome as internal committees have to approve the change. A good specialist in sales will feel when the wind is about to change and will have called his client base before the news hits the wire. The impact of the regulation has had an adverse effect. Although recommendation changes are now visible to all parties at the same time, large blocks will have been dumped in the market beforehand. In November, some large Apple blocks hit the market, without any material news or rating changes. Analyst recommendations now lag trend reversals with a larger delay than before.
Analyst price target competition
The level playing field on stock information makes it harder for brokers to differentiate their ideas from others. With a hot stock like Apple, analysts often compete with each other on setting the highest price target. In the internet broking era, the price target is like an advertising banner that determines the bullishness of the research material. Analysts push their valuation methods to ever bolder targets in an attempt to get attention. The valuation case is limited to a P/E only, as it looks good on the Apple past growth record.
Research remuneration limits objectivity (This is a Big Problem)
Historically, the investment bank charges a commission to its institutional clients for the execution of an order. As the commission rates declined from 0.25% to 0.05%, a conflict arose between execution compensation and research compensation. The investment bank needs to make a return on its research efforts and analyst salaries. At the same time, it also has to make a competitive price for the orders. The decline of trading commissions make it hard to charge an additional research cost to clients. New trading platforms have also channeled flows away from the traditional commission generating flow. Investment banks need a minimum of flow in order to generate more flow and make trading profits. Trading spreads have become a larger profit generator than research compensation. Research envelopes are sometimes negotiated with large institutions, but most institutions prefer to build their cheaper buy-side analyst team. As a stand-alone department, the investment bank research division has become a pure cost center. Still, public companies demand a recommendation on their quoted stock by the large investment banks. Investment banks abide as they can make big tickets on the corporate advice activity. Although there should be a strict separation of both banking sides, there is a subsidy from the corporate finance department to keep the research division afloat. This can be done by transferring internal costs. Without any traceable evidence, this will automatically put some pressure on the analyst.
Insiders are really outsiders (Another Big Problem)
Although analysts are top business school graduates, they often lack the technical skill to understand the real drivers behind certain products. Those analysts rely too much on the management and investor relations for technical information on the products and the manufacturing. In fact, they have selective access to information. Every analyst is branded by the management as a potential beneficiary or threat to their wealth. Any personnel contact between the company, its employees and an analyst can create inside information and could be liable to prosecution. The analyst has the power to materially influence the share price. If the same person would leak some information to your neighbor, then that is not considered material to the market. Hence, the analyst is often the last person to pick up certain trends that the investor relations department has strategically omitted or denied. The IR job is a massive conflict of interest as the IR is often remunerated on share price appreciation.
Reality check
Wall Street is not Main Street. Only a couple of years ago, Apple was a nimble company that made great publishing desktops. With the iPhone, Apple changed the mobile space forever. The iPhone thrived in the fast wheeling/dealing biotope of the investment banking world. Long before Joe six-pack bought an iPhone or iPad, they dominated every investment conference or business hotel lobby. However, the universe of analysts and opinion makers on Apple is by no means a reflection of the real world. The steep hockey-stick adoption in the investment community might not get replicated in the rest of the economy. Bakers and butchers have different preferences. On a larger scale, the Apple love-story is automatically transferred to the rest of the world. Apple is a typical U.S. success story of a come-back kid and the enigmatic figure of Steve Jobs.
Hic et nunc dominates for hedge funds
What we see here and now determines our view of the future and the past. This reminds me of medieval painters that picture Jesus in clothing of the year 1500. There is no worry in the market that Apple's current extreme margins of 35% can normalize back to 20% or lower. The rise of hedge funds in the trading mix, forces the analyst to think on a horizon that is too short. Short-term trends are then extrapolated on a steep curve. The short iteration of 2 success stories, iPhone and iPad, have pushed the bearish analysts into capitulation. Apple profit expectation now demands that they come up with a game-changing product every 1.5 years. Although technically that is still possible, the likelihood is very small.
Being bearish costs jobs
Stock price corrections usually happen faster and take less trading days to realize the same percentage move. This asymmetry means that bullish analysts get it wrong on less trading days. Because the market tends to move higher, it is safer to have a positive bias and jack up target prices as the share price catches up. Investment banks have to publish their percentage of buys, sells and holds. These statistics still skew around 75% to buys. That is only possible if the few sells are on the largest stocks. In the end, it should all add up to a zero sum game as the sum of all stocks should perform equal to the market. I once heard a head of research reply to this criticism that they only rate the good companies. Apple brought so much wealth and optimism to the tech segment that it is hard to put a knife in it.
Quant funds don't reason
Quant funds are usually low volume traders as trading costs eat away the small commission revenue. However, they will act quickly as they measure small changes in the analyst sentiment. They will try to anticipate the rating changes. They must have picked up a significant number of analysts that nudged down their numbers after the summer. Some analysts actually increased their targets as it was considered a timing effect and sales slipped into the next quarter and other excuses. Quant programs, however, don't reason or have any emotional link with Apple. They never heard of Steve Jobs and what his innovations have done for our daily lives. Quant funds just pulled the trigger and pushed the share down. This selling hit a very important other factor in quant program: momentum. With momentum down, more selling emerged. The price correction made some analysts cut their numbers and the quant program ran a new iteration and so on. Throw in a margin hike, a dead cross, and before you know it, Apple becomes a falling knife.
Conclusion: make your own homework
As an analyst, I regret the current dangerous market environment for fundamental long term research. Trends are extrapolated into ridiculous territory as the interests of investment banks, hedge funds, quants and also ETFs are not aligned with the individual investor. However, with good discipline and patience, you can make more profit from these anomalies than before. I wrote a piece on the Nokia mispricing on 17/10 and stand 40% in the money. I believe that independent analysts are the future. With information access now leveled, you can piece together your own data sources and build a good financial model with realistic assumptions. You have to leave a safety margin of at least 30% as the market will exaggerate more than before. Amazon (AMZN) looked expensive at $200, but that might not prevent it from rising to $300 before going to $50. Watch out for the short squeeze, and pick either very large companies that can't be taken out or that have a small short interest. Watch insider sales, as you don't want to bet against the CFO.
My Apple DCF target is still $500. I will become a buyer at $380, and a seller again at $650.
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