Jeff Miller | Nov 30, 2013 11:59PM ET
How useful are the forward earnings estimates of the sell-side analysts?
There is a widely-circulated chart that reinforces the popular viewpoint that analyst forecasts are hopelessly optimistic. It comes from a Morgan Stanley research note, first called to my attention by a reader who writes frequent and thoughtful comments, "CautiousInvestor". I knew immediately that there was something amiss, but I wanted to see the original context of the report. Now here . I have frequently noted that most pundits simultaneously claim two things:
If you think about these two propositions, it suggests that there is a crossover point where the estimates are pretty good. My research shows that estimates are pretty good if you limit the forecast to the next twelve months. The Morgan Stanley chart suggests that my conclusion is wrong. We would all like to have better forecasts of earnings, so this is a good topic for research. If we simply cannot forecast earnings effectively, so be it. Let us dig deeper.
The Attention Grabbing Chart
I will be working with the two charts from Josh's article, although the first has appeared in many places.
Here are some of the questions that should immediately come to mind:
My conclusion is not that the chart is not accurate, although it would help to see the underlying data. It is yet another example of taking data and creating a false impression.
Compare this with a typical chart from Doug Short. When there are many variables, he makes the data come alive by showing the effect of each. This chart takes a complex situation and incorrectly reaches a simple conclusion. The error of this method is the reason that those analyzing forward earnings use a "squiggle" chart. Let us dig still deeper.
The Squiggle Chart
A different Morgan Stanley branch produced the second chart Josh cites. Here it is.
The researchers have bamboozled you by focusing on the "early line" that no one cares about. Most of the dramatic declines occur in this period, a preamble to the actual earnings year. If they were to redraw the squiggles with an accurate scale, starting at the beginning of the year, you would see a very different picture. Since they have the data, someone should ask them to produce such a start.
Conclusion
Forward earnings provide a valuable information source for truth-seeking investors who want an edge. Here is a good summary:
An astute investor should embrace this valuable source of data, following the updates on forward earnings.
A Personal Afterthought
This post may have required the most time and effort of anything that I have ever done. I did the work because the subject is important. It goes to the heart of the current market debate about what to expect next year. There is absolutely no payoff for publishing this kind of research. I already knew the conclusion. The extra hours come from explaining it clearly.
It is much easier to do short posts that cater to the popular mood. Instead, the result is a long post that runs counter to current prejudice. You need to be open-minded, intelligent, and patient to consider the various points. People would rather read about whether we are in a bubble.
The incentive structure for this sort of work is all wrong. Street research is not peer reviewed. It is often misleading. The top research teams get paid high salaries to do this full-time. Guys like me spend our evenings and holidays trying to shine a light. No one shares the underlying data, even if there is nothing proprietary about it. That raises the barrier for anyone trying to understand the work.
Investors are skeptical of sell side earnings estimates, but blindly accept research charts like these. They should do the opposite.
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