Trying to navigate your way through the world of investment opportunities and risks is difficult even for the professionals. For everyone else, an added challenge to overcome is the confusing and overly complicated messages that come from those giving the advice and crunching the numbers.
Most investment advisory firms that include shares as part of their offering will have an in-house team of research analysts. There are analysts for all manner of things financial, including shares, economics, strategy, fixed interest and commodities. For the purposes of this column, I'll be referring to the analysts that cover shares.
All the companies on the sharemarket are divided into groups and each analyst will generally follow somewhere between six and 12 companies. In larger markets they are each responsible for a specific sector. In Australia the designated mining analyst might cover 10 mining companies while the banking analyst covers six banks. Because New Zealand is much smaller, analysts are usually multi-sector and may cover several companies from different industries.
Their job is to become an expert on these particular companies and the industry in which they operate. They will visit the factories and operations, talk to executives, competitors and customers, and conduct extensive industry analysis. Their job is to learn as much as possible about each company's strengths, weaknesses, risks and opportunities so they can impart these insights to their information-hungry clients.
Most share investors or market followers will have come across an analyst research report on a specific company at some point. These reports contain a wealth of information and can be very useful for investors who want to learn about a company, its industry, its growth prospects and its risks.
However, they are nearly always written with professional investors in mind and consequently are loaded with jargon, complicated concepts and an abundance of intricate charts. Because of this, most retail investors, otherwise known as non-professional, mum-and-dad or private investors, find these reports of limited use. With some reports stretching into dozens of pages, retail investors probably don't have the time to read them cover to cover either.
An analyst's report on a company will usually contain a recommendation that summarises their opinion on the shares. Different terms are used to describe these, with the most common being the traditional "buy, sell or hold". Some will use other phrases such as outperform, overweight or accumulate (all the equivalent of buy) or underperform, underweight or reduce (all meaning sell). Hold or neutral usually suggests the analyst believes the company is valued about right.
There will also be a "target price", which represents the price the analyst believes the shares will reach over a certain time frame, usually over the next year or so. Generally, a target price that is significantly above the current share price is accompanied by a buy recommendation (as the analyst is expecting the share price to rise) and vice versa for a target price that is significantly lower than the current share price. When a target price is close to current levels, for example within a 10 per cent margin, a hold or neutral rating is usual.
A common mistake of retail investors is to place too much emphasis and reliance on the recommendation and the target price. Although these aspects of a report often get the most attention, they are probably the least useful. Ironically, these are often ignored by many of the professional investors the research reports are primarily written for. These investors, such as the managers of large superannuation and KiwiSaver funds, are more interested in the body of the report than the recommendation.
They will look for a new perspective or an insight they may have not considered, they will be interested in what sort of assumptions the analyst has made when calculating his or her financial forecasts and they will use the analyst as an additional information source to find out as much as they can about a company.
A huge amount of time goes into valuing a company. Complex financial models are built that forecast future profit over many years and potential risks and opportunities are assessed and estimated. However, it remains imprecise and is as much an art as it is a science.
There are a huge number of factors to be predicted and estimated that could affect how a company could perform, including company sales growth rates, profit margins, currencies and future interest rates. It is possible to make a reasonable estimate of what these may look like over the next year or two, but estimating these factors several years in advance is very difficult. Changing one future variable can have a large impact on the final answer that the model calculates.
Some may say such financial models are a guess divided by a guess, which is probably a bit too cynical, but even the most passionately academic analyst will admit they are only as good as the assumptions they are based on.
There are also many unexpected scenarios that simply cannot be incorporated into such models. It would have been very difficult to forecast that Port of Tauranga would see benefits from disruptive industrial action at Ports of Auckland, or the impact that the PSA virus would have on companies involved in the kiwifruit industry.
It should also be noted that there are always a range of views on whether a company is a good investment or not. For example, according to Bloomberg there are 17 analysts that cover Commonwealth Bank, Australia's largest bank and the owner of ASB in New Zealand. Of those 17, five have a "buy" recommendation, four say "sell" and eight have "hold". Different perspectives always exist and analyst reports represent a point of view, rather than an exact answer.
Another mistake retail investors make is to browse through broker research recommendations, ignoring anything with a "boring" hold and looking for only those companies with a "buy" recommendation and with a target price far in excess of the current share price. This can be a poor strategy as many good quality companies end up being ignored. Higher quality companies tend to trade at above average prices due to their track record of delivering consistent returns over long periods of time, which can mean analysts overlook them in favour of companies that look cheaper.
A question that is often asked is where are all the sells? It's a fair point, as there always seems to be an abundance of buys and holds and very few sell recommendations. When it comes to company reports, it could be that analysts are an optimistic bunch (in the same ways economists are naturally pessimistic).
A more likely reason is that a sell recommendation on a company is a good way to get offside with company management. This is of concern to an analyst because it may make it difficult for them to get the same line of dialogue and information flow that they may have had previously. It's easier and more politically correct to have a hold recommendation and communicate the negative view with the tone of language used in the report, so in some cases an analyst may say "hold" when they really mean "reduce".
Analyst reports can be helpful when gathering information on a company. However, retail investors should take a more holistic view when choosing which shares to include in their portfolio, rather than relying too heavily on recommendations and target prices.
These factors help provide a guide when making investment decisions, but rather than being viewed in isolation they should be considered alongside other important elements such as quality of management, balance sheet strength, earnings track record, dividend growth potential and any strategic assets.
Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.