In the past, analysts and investment managers felt that intensive fundamental research and modelling provided an edge when it came to picking strategies
and investments. Many thought that it resulted in appreciably higher returns. Certainly, it would seem logical that the added work of poring over financial
statements and news releases would allow for a greater understanding of the underlying prospects of a company and its potential for future profitability.
At the very least it would provide for a means to benchmark good or bad investment opportunities, by having a clearer picture of the cross-sectional
aspects of publicly traded securities – maybe leading to informational asymmetry (an academic way of saying “I know, or can get, information that you
can’t, and I can use it to my advantage”).
For the longest time, it seemed that detailed analysis did in fact provide an added level of value. That value was attributable to the fact that if only a
few analysts covered a stock, they had an opportunity to find a gem that no one else had caught on to yet. However, what happens in instances where 50+
analysts are covering a stock? Being able to uncover nuances that the other 49 analysts haven’t becomes far less likely and far less valuable. Finding that
hidden gem becomes harder and harder the more analytical eyeballs there are that are building valuation models and forecasting the future. We’ll talk about
this in a bit, in the context of something called the S&P Indexes Versus Active Funds (SPIVA) scorecard.
In addition, it would seem obvious that little certainty or long-term predictive power can be gained from simply looking at the pricing movement of a
stock. Mind you, there is a discipline in the investment industry known as technical analysis which tries to do that.
Does technical analysis really work?
Technical analysis is, broadly, the study of past and current pricing movements to forecast future pricing movement. It does have some ability to provide
context and understanding to short-term supply and demand pricing behaviour and has, in certain instances, been used to try and identify appropriate timing
to buy and sell.
However, I’ve yet to see many studies that show technical analysis having a persistent ability to forecast long-term stock trends – at least, not without
the integration of other forms of analysis. A fight has raged on for both sides (fundamental or technical) for decades as to which type of analysis produces value-add. The value most likely can be found in the integration of both styles when making decisions about buying and selling securities.
All I can be relatively confident of is that stocks will tend to move up over a very long time, and they can sell off drastically over short periods of
very high volatility and risk.
Do analysts bring value?
I know that analysts and investment managers will get their backs up immediately at having their forecasting ability called into question. It isn’t my
intention to paint the whole industry in a poor light, because I do believe that there are professionals who do a great job of identifying investments with
the potential for good performance. However, overall, my industry has done a mediocre job of delivering on their expertise.
As evidence of this, I cite a study by Mark Bradshaw of Boston College and Alan G. Huang of The University of Waterloo, which focused on aspects of
accuracy of stock analyst price targets. The very title sums up the content: “Analyst Price Targets Optimism Around the World.” In brief, the study goes on
to show that stock target prices aren’t very accurate and can often be influenced by bias and lack of analyst independence through their affiliation with
investment banking and other finance activities.
Another study in a publication of The Research Foundation of CFA Institute, written by Jennifer Francis, Qi Chen, Donna R. Philbrick,
and Richard H Willis titled “Security Analyst Independence,” showed similar findings back in 2004.
Some will argue that these issues are problems related only to sell-side analysts (the type employed by brokerages that also have investment banking
relationships), and that may be the case, but the buy side (private money managers and mutual funds) isn’t without its own issues to overcome. Looking at
the SPIVA reports issued by Standard & Poor’s, it’s clear that
mutual fund managers have a difficult time at beating an index over the long-run.
Adopting a holistic approach
What have we been able to uncover? I wrote recently on how the investment
industry hones its marketing approach to appeal to our psychological weakness of buying into nuanced explanations of how to generate returns. This article
identifies pitfalls related to accuracy of investment targets.
So, what do we do? Why do low-cost strategies like exchange-traded funds (ETFs) tend to beat active money managers? Can we rely on our own due diligence
that is based on sell-side analysis, which has shown to lack independence and accuracy concerning pricing targets?
I think the answer lies in the holistic approach of borrowing a little bit of traditional fundamental “tire-kicking,” using aspects of a technical approach
that holds we can pinpoint times to buy and sell depending on a trend in certain metrics, and finally adding the rigour of adhering to a systematic
approach that tries to remove as much subjectivity as possible (almost like an ETF).
In a future article, I’ll start to explore aspects of applying a systematic approach to investments that can help us avoid some of the pitfalls I’ve
outlined here and in my previous article.
Mark Taucar, CFA, manages discretionary client assets through Bespoke Discretionary Service for Accilent Capital Management Inc. He has also built and managed discretionary referral platforms for other
notable Canadian money managers. Over the course of the past 10 years, he has managed institutional, pension, high net-worth and direct-client assets.
His systematic investment strategies are used today by various firms in the industry
. Mark can be reached by phone at 905-715-2260 or by email at email@example.com.
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