Beware of analyst bias

If you receive research from a company that has a stockbroking arm, beware of the potential for bias.  While all brokers say they have Chinese walls setup between their Equity Research and Investment banking businesses, at the end of the day, its the same company. Research can affect the investment banking side of the business. Also beware of the following issues.

1. Brokers make money when you trade as they don’t charge for their research (depending on how much brokerage you give them of course), so research analysts are encouraged to make Buy/Sell recommendations rather than Hold recommendations. If they ranked all stocks as hold, no one would buy or sell, and they wouldn’t make any money.
2. Analysts don’t like to upset companies by issuing negative research or sell recommendations. This can have adverse consequences with the company choosing to take their business with other brokers and/or cutting the analyst off from access to the company.
3. By issuing favourable research, it can mean that companies bring more business to the broker and give the analyst wider access to company resources e.g. the company may decide to issue shares, and pick this particular broker to underwrite the issue or provide advice.
4. Analysts also don’t like to upset fund managers, (who are their major clients), by issuing negative research that could have a negative impact on a fund manager’s shareholdings.
5. Analysts are usually restricted from reporting on companies for which another part of the brokerage is doing business. This may mean that an analyst’s last research is outdated, or the analyst’s view could change, but you might not know about it for some time.
6. Analysts are rarely assessed and paid based on their accuracy of recommendations, but rather by the amount of brokerage they bring in.
7. Many analysts are students of Efficient Market Hypothesis (Efficient-market hypothesis – Wikipedia). This basically states that market prices reflect all known information, and as such its impossible to outperform the market.  Analysts also use CAPM (Capital asset pricing model) to value stocks. CAPM has many failings, but the major failing is that it uses a component called “Beta” to identify the risk of an asset. Beta is calculated by the variance in a stock’s price compared to the whole market. How you can use a stock’s price  to calculate how risky the company is seems ridiculous to me.
8. Many analysts use Excel spreadsheets to model companies financial data and to calculate their forecasts. The issue is that as more and more variables are added, tiny errors can compound into massive errors and the end result could be wildly wrong. as Warren says “Its better to be roughly right, than precisely wrong”.
9. Many fund managers rely on “consensus” data. That is to say, they rely on the average forecast of many analysts. However, if an analyst provides forecasts that are very different to consensus, there is pressure to “adapt” their forecasts back inline with consensus.

In summary, be very careful of forecasts and recommendations that are provided by broker’s research analysts. It would be better to pay for your research from an independent research provider. You still want to be careful here, as there may be unseen bias e.g. links to companies.

The downfalls of using ROE to value a company

Many investors use ROE (Return on Equity calculated as Net Income / Shareholders Equity) as a means of valuing a business, or judging a business’s performance.  However, the more debt a company has, the more likely it is to have a higher ROE. The level of equity can be reduced by increasing debt, thereby creating an artificially high ROE. If a company has no debt and a high ROE, then this might be a company to look at closer, or keep an eye on. Also look for companies increasing ROE, while maintaining or decreasing the level of debt. My approach is to use ROE, but also ROCE (Return on Capital Employed calculated as Net Income / Shareholders Equity plus total Debt). I also look at the average ROE & ROCE over 5, 10 years, and see what the trend is.

Avoid the Myer IPO

If you are thinking about buying shares in the Myer IPO, forget it. You are being ripped off. Don’t get caught up in the excitement of it all. As an investor, you need to stay calm and cool-headed. If you analyse the companies pro-forma financials, you’ll realise that Myer share’s are expensive, its main assets are approximately $1Bn of intangible items, which includes “capitalised software expenses”. Yep that sure sounds like an asset to me……NOT.