Saturday, June 02, 2007

The value of analysts' reports

For those of you who rely heavily on analysts' reports in order to buy or sell shares in companies, let me pose this question: how much can you rely on these reports, and are they really serving the interests of the shareholder ?

First, let's analyze the analyst himself (I use a male to denote the analyst, but I know many female analysts myself, this is just for convenience sake !). The analyst has got himself a job at a brokerage house doing research and reports in order to earn a fixed income. His profession allows him to get up close and personal with company's management as well as visit the location and premises of their factories and offices (if overseas) to get a better feel of the company and their potential. Armed with this knowledge, he will proceed to write a report (usually glowing) on the company, analyze the financial figures (usually consists of forecasts) and come up with a target price.

So how is the analyst connected to the shareholders of the report for the company in which he reports on ? The answer is: NONE ! The fact is that analysts are salaried employees whose job is to understand Management and operations in the company he is researching in order to produce a meaningful report. Granted, the report is for clients who may or may not be shareholders of the company, but usually the report is not specifically prepared only for shareholders, but also for interested investors. However, a problem arises here in that the analyst becomes detached from the interests of the shareholders because he is reviewing the company from the point of view of the "outsider". Some may argue that this enhances objectivity and rationality when it comes to financial and management evaluation; but it's a double-edged sword as it also means that the analyst may not bother being "detailed" enough as this is just one of the many companies he has been tasked to research.

Let's use a simple example: Ezra Holdings Limited. I have been a shareholder of the company since October 2005 and in the process, have read up everything I can about the company, browsed through 2 years of annual reports and even spoken to key management personnel on their strategies. I do remember reading reseach reports from CLSA written by a certain Jason Wee who used to initiate coverage on Ezra. Recently, to my surprise, the analyst in charge of Ezra has been replaced by a Caroline Maes. There have been cases too when I noticed that certain companies report having a change of analyst covering it.

An immediate problem arises in such situations. 2 different analysts covering the same company will surely have different views and ways of analyzing the company. Thus, there may not be much continuity in the coverage given by the analyst on the same company (in this case, Ezra) considering that there was a change in analyst. The shareholder (i.e. me) however, will always have a consistent vested interest in the company and will continue to research on the company's prospects and progress by taking a value investing approach. Therefore, is it fair to assume that fully involved shareholders can probably understand and write a more comprehensive report on the company than any analyst ? This is my argument and I know there is no right or wrong; it's just that I am merely trying to tell readers that analysts may not always be the best people to turn to when analyzing a company; sometimes there are others who know even more than analysts, and they are the value investors who have stayed with a company through thick and thin.

Another issue I have with analysts is that they can be wildly incorrect or spot on in their analysis, but they will always get paid the same. Furthermore, can someone name me an analyst who got severely reprimanded or fired because he issued a report with a totally inaccurate target price ? Apparently, readers have to realize that a lot of the analysis and conclusions are based on (sometimes) flimsy, overly optimistic forecasts of future performance. This can decouple the reader from the reality and cause an expectation gap ! I have observed analysts being 180 degrees wrong in their analysis of a company, but I did not observe any major repercussions. In the end, the losers are the ones who faithfully lap up every single analyst report without doing some independent, logical thinking of their own. Who else can you blame if you buy without a margin of safety or based on pure hope ?

Warren Buffett has continually emphasized independent thinking, which means thinking clearly and objectively and based on facts and rational reasoning. As human beings, we are swamped with tons of information everyday from all sources, including analyst reports, friends' recommendations and pundits pushing certain industries or companies. The right thing to do is to filter out all the noise (usually about 95% of what you hear) and focus on what's important (the remaining 5%). Once you have the clarity of mind to think through an issue or to analyze a company, then analysts reports will become just that: analyst reports ! Good for bedtime reading and to give you some ideas, but not good enough to base your investment decision solely on.

The next time you come across an analyst report, read through the entire report word by word and think about what the analyst is saying. The section below describes my reaction to reading a report by DBS Vickers on Pacific Andes, one of my investments.

Pacific Andes Analyst Report - DBS Vickers

I would assume everyone has a copy of this report as it is freely available on the website (see my links on the right), thus I will not "copy and paste" the contents of the report. Rather, I would like to add my comments and opinion on what the analyst has already said, as I am coming from the point of view of a shareholder who has observed the business for more than a year.

Generally, the report is well-written and accurate in describing the company's current state of affairs, as well as the SGM coming up and the impending acquisition of 63.9% of CFG and the 1:1 rights issue. The report also attempts to come up with a target price (I call it intrinsic value) for PAH ex-rights, after taking in 63.9% of the profits from CFG. The analyst had a target of $1.24 pre-rights and $1.04 post-rights, assuming the company went ex-rights at a market price of $1.16 (PAH closed at $1.20 today).

The sensitivity analysis is quite well done, except that it misses a crucial aspect: the future earnings potential and vertical integration enjoyed by PAH, PAIH and CFG. Most analysts' reports are pretty accurate with the numbers (hey they are trained in that !) and can use DCF, sum of the parts and PER to value a company. However, as I mentioned, the fact that they use the term "target price" shows that they are only evaluating the numerical and financial aspects of the company. What is intangible is the company's competitive advantage, exclusive fishing licences from the Peru acquisition, scaling up of operations downstream as they move into fish SCM and fishmeal processing, economies of scale in managing a larger fleet of purse seine vessels as well as cost reductions on negotiation of the 4th VOA. All these factors alone will command a premium when viewed objectively, thus the intrinsic value of PAH will definitely be higher than just $1.04 ex-rights (using 10x FY 2008 PER). The analyst had also failed to project for the earnings growth of PAH, and thus the numbers used are purely from FY 2007's profit, which is historical and rather useless for predicting the future intrinsic value of the company.

Thus, from this example, one can see that analyst reports may not account for everything; and the discerning shareholder should seek to learn more about the company in which he has a stake, in order to form a more well-rounded opinion on the prospects of a company. A long-term approach also helps as one can think of the business as evolving, without a singlewell-defined intrinsic value but more like a rolling, increasing value. The target prices set by a brokerage firm are merely static targets which are probably outdated in about a month's time. This is the dynamic nature of investing and understanding businesses, which is why value investing is almost a full-time job !

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