Thursday, October 18, 2007

The Folly of Target Prices

Looking at the dearth of analysts reports being churned up daily, one can only wonder about the accuracy of such forecasts and predictions. I had commented once before previously about the utility and usefulness of analyst reports, since most of the time brokerages are being paid to produce churning in shares. Remember that the more churning of shares there is (i.e. frantic buying and selling, contra, short-selling and punting), the more money brokerages (not the retail investor !) will make. Brokerages thus have a vested interest in writing such reports, even though on the surface it would seem that they are "helping" investors by recommending what to buy and sell.

What I must add is that the analysts themselves are not to be blamed; most of the time they take instructions from their bosses who are eager for a report to be written so as to “promote” a particular company. This in turn can create an “avalanche” effect as other brokerages also jump on the bandwagon to issue reports on the same company, thus creating a domino effect on prices. For better or worse (usually worse), punters and speculators will jump on every newly released report as a sign that it is the “next hot tip” and that the stock will either move up or down by 10-20%. Exacerbating this problem is that fact that almost all (95%, with the exception of some OCBC) research reports come with target prices for companies.

What is my issue with target prices ? If you noticed for my previous postings, I do not mention or bother about having target prices for the companies I own. A business is dynamic by nature and the concept of having a target price simply implies that there is already a set PRICE at which one has targeted to sell, which actually contravenes value investing principles. Recall my previous posting about “Knowing When To Sell”, where I mentioned that a value investor would sell under four stringent conditions involving the judgement of the intrinsic value of a company, or if fundamentals were eroded to such an extent that no margin of safety exists. The very act of setting target prices for buying and selling seems to imply that the reports are heavily price-driven, instead of being driven by the underlying fundamentals and prospects of the company.

This is the chief reason I do not bother about target prices for selling or exiting an investment. If one has intimate knowledge about a business and knows the future potential of a company within an industry, the cue to sell would only come from a slowdown in the industry (an erosion of fundamentals) or an errorneous judgement call with respect to the intrinsic value of a promising growth company. After all, the intrinsic value of a company changes almost daily as business activities within the company are in constant motion and change, so how can one comfortably settle on a price for a company on any given day, let alone a “one-year price target” preached about by so many brokerage firms ? The entire world out there is so price-centric that most people would rather ask about a company’s share price BEFORE asking about the company’s principal business, target customers and profit margins. It is this pervasive and persistent focus on price which we have to avail ourselves of before we can drill down into the true value of an outstanding business; as value investors we should strive to be business analysts, and not price analysts.

Thus, one should look at analyst reports for the possible insight into the business fundamentals and assumptions used by the analyst in projecting earnings flow. Since analysts do have better access to company resources and can meet up more regularly with company Management than the average retail investor, this does give them more insights into the business and latest assertions made by Management. All one needs to do then is to ignore the target prices set by analysts and absorb the facts; this will then make reports useful and eliminate the price-centric bias.

8 comments:

Anonymous said...

Hi MM,
I hv long been wondering on the topic of when to sell which you hv so wonderfully discussed previously. Take a recent transaction for me. I bought SPC @ 4.48 Nov06 and sold it on 25Sept @ 6.40. The reason for selling it was that refining margins (their core biz) has dropped from its high by 50%. But once I sold it, SPC announced its oil field is pumping out some oil which influenced the price to jump to its current all time high region in >8.50.
As I'm hv v little experience in investing, I can't help but feel the horrible upset even though analysing tells me I made an informed decision.
Also, another reason for selling is tt i noticed Saudi made OPEC pump out 500kbpd more. My reason is tt since oil is inelastic gd, it doesnt matter wad price it is, ppl still buy, so if Saudi made OPEC pump more oil, I infer tt MidEast has no confidence in the world economy. (if world economy tanks, price of oil drops Mideast lose $$. better to keep drug addict alive but earn less than dead)
Wad factors hv I failed to consider then?
Kharsp

Anonymous said...

Kharsp, sori to intervene... actually investors knew way ahead abt ouyang field and that it is expected to start contributing at year end of 2007...at the beginning of 2007. So perhaps u were a little 'misinformed'...

another pt to add is that u r rite abt refinery margins.. (in my opinion) however, somehow local investors seem always to equate the crude oil px to SPC stock price.. w/o regards to it's refinery margins. although it core biz is in refinery. I've long given up trying to reason y pple do that.

cheers, sj reader.

mw: hope u don't mind my intervening

musicwhiz said...

Hi Kharsp,

It could be possible that you did not consider all aspects of the business before investing, which SJ Reader suggested. Admittedly, it is not an easy task as it can be daunting to analyze a company with specialized business or very technical aspects. Nevertheless, we must still try. Do not blame yourself for missing out something crucial as we are all human and should learn from our mistakes and omissions.

I feel that the future of oil prices will be dependent upon how well human beings can adapt to alternative fuels, and whether there can be a significant alternative fuel which is cheaper than and can be produced in greater quantities than petroleum. As it is, even nuclear energy cannot totally replace gasoline and concepts like solar energy and bio-diesel are still far from replacing oil. Even though analysts predict that oil may run out in 50 years time, a lot of our vehicles are still powered by gasoline and so it would take a major revolution and industry shakeup to change ALL vehicles to accept a new form of fuel.

Regards, Musicwhiz

musicwhiz said...

Hi SJ Reader,

Sure, I don't mind at all. That's what a blog is for, to exchange ideas and to share knowledge. I would be happy if there can be constructive discussion even through a comments column within my blog !

Thanks for helping to clarify certain aspects of SPC. I am not into crude oil E&P companies and so do not know much about refining margins and such.

Regards, Musicwhiz

Anonymous said...

Hi all,

Thx for your comments and i guess i'll hvta wait for a proper correction to kick in. Maybe news like failure to meet EPS will oso readjust the pricing a little.

Btw MW, in the problem of determining selling, it seems to me tt Ezra earnings has to play catch up wif price. So my guess is tt u gv "bonus marks" for Ezra's one-stop oil n gas services strategy?

Kharsp

musicwhiz said...

Hi Kharsp,

Yes, I agree Ezra's earnings has to catch up with its price as currently, valuations are very demanding. Well, I do not really see it as "bonus marks" which I take it to mean that they occupy a premium position and have a unique competitive advantage such that they deserve to have a higher intrinsic value.

I guess it's more of looking at the prospects of the company growing its earnings. Right now, they have listed EOC and gained access to European capital markets, opened a new office in Aberdeen to tap more opportunities and also scaled up the operations of Saigon Shipyard. Thus, there is much to look forward to in terms of earnings growth and as a shareholder, I am optimistic that Management can deliver.

Regards, Musicwhiz

Anonymous said...

hi mw, i find it interesting the disclaimer from foreign analysts reports different from those of s'pore based, some openly declared their interest in the coy reported! should one then take the report differently? in your opinion, who's report io more credible?

musicwhiz said...

Hi there,

Oh, actually I did not realize that foreign brokerages openly declared ! I guess in such cases, investors must know that the report cannot be totally objective. We should then use an appropriate discount factor to factor in the estimates which the analyst has used. I guess that may be the best way to mitigate the "risk" of being misled by someone with a vested interest.

Regards, Musicwhiz :)