Why (And How) We Need Financial Analysts

The senior portfolio managers of Tocqueville, a collective trove of investment experience, periodically make presentations to our junior analysts on “How I Invest”. Recently, it was my turn to engage in that educational endeavor, and I decided to start by quoting a couple of studies that have confirmed the superior performance of value investing over time.

Mechanical Approaches to Value Investing

Starting with a 1992 book entitled Beating the Dow, by Michael O’Higgins and John Downes, I described the “Dogs of the Dow” method. It consists of selecting once a year, among the thirty stocks in the Dow Jones Industrial Average, the ten with the highest dividend yield. Despite this embarrassingly simplistic selection criterion, the Dogs of the Dow discipline produced an annual total return (including dividends) of 17.7% over the 23 years between 1973 and 1996 -- compared to 11.9% for the overall Dow Jones Industrial Average.

After quoting a few similar studies, I finished with one, published in 1993 under the auspices of the National Bureau of Economic Research, which impressively vindicates the combination of the value and contrarian approaches.

In Contrarian Investment, Extrapolation and Risk, the authors[i] screened a very large database over 23 years (1968-1991) to compare the performances of “value” and “glamour” stocks.

One of the most counter-intuitive and intriguing findings of this study is that, on average, the stocks of companies with the poorest sales growth over a five-year period subsequently outperform, by a wide margin, the stocks of companies with the best historical sales growth. This illustrates how investors and analysts, who generally tend to extrapolate past growth into the future, usually wind up paying too much for it. It is also a striking vindication of the contrarian approach.

The full study compares the performances of value and glamour stocks.

·        Value stocks are defined as those with low ratios of price to earnings, cash flow, book value, sales, etc. These low ratios are interpreted to reflect poor investor expectations of future growth.

·        Glamour stocks are those which investors expect to have high sales growth (extrapolated from the growth of sales in the most recent five years), and for which they are willing to pay a higher ratio of prices to earnings, cash flow, etc.

The authors find that stocks with both poor past sales growth and low ratios of prices to cash flow constitute the best performing group in the study, outperforming glamour stocks by an average of 8% per annum over the following two-to-five years.

The ease of selecting winning stocks with these relatively simple, mechanical approaches led me to ask a question: “Why do we need financial analysts?” This may seem a paradoxical question for the founder of a firm deeply rooted in fundamental research, but it did not imply that analysts are useless – simply that they usually focus their analyses on the wrong data.

Why We Need Financial Analysts

Screens such as the ones described above work well in theory but have shortcomings in the practical world.

The Dogs of the Dow approach, for example, produces a portfolio of only ten stocks, with frequent overlapping by several stocks belonging to the same, or related, industries. It does not allow, therefore, for the degree of diversification that most fiduciaries would consider prudent. (In Fooled By Randomness, Nassim Nicholas Taleb points out that techniques that have been faultless for very long periods can still wipe out their practitioners when a “rare event” occurs).

The contrarian-value screen used in the second study, starting with a database of several thousand stocks, produces portfolios of several hundred stocks. This is too many securities for most portfolios. It also raises a psychological problem expounded in yet another study published by the National Bureau of Economic Research: Myopic Loss Aversion And The Equity Premium Puzzle (Schlomo Benartzi and Richard Thaler – 1993).

The authors start by asking why, in view of the demonstrated superior long-term performance of stocks over bonds, investors still bother to own fixed-income securities such as bills or bonds. The reason, they conclude, is that investors get more pain from short-term losses than they get pleasure from long-term gains. They describe most investors’ willingness to trade superior long-term performance for short-term stability as “Myopic Loss Aversion”, a condition that worsens proportionately to the frequency with which investors look at their portfolios.

In the case of very large portfolios made up of hundreds of deep-value, contrarian securities, it is probable that many of the best-performing stocks owe their performance to the fact that their companies were on the verge of bankruptcy at the beginning of the review period (which is why they were so statistically cheap). Some subsequently recovered, leading to very strong stock performances. It is just as probable, however, that a number of these fragile companies actually did go bankrupt during the same period, leading to huge stock losses. The superior performance of the total sample probably is due to fact that large losses on the “casualties” were more than offset by the very large gains on the shares of companies that survived and recovered. Myopic loss aversion, either by the portfolio manager or his clients, would certainly be encouraged by a portfolio where a number of companies go bankrupt every year, raising concerns that the manager is not “in control” – even if the overall performance is excellent.

Furthermore, most of these techniques, regardless of their long-term success, experience periods of marked underperformance (often while “growth” stocks or those of the largest companies outperform on the upside), and this could further increase the clients’ feeling of uncertainty.

As I have tried to demonstrate, simple and mechanical techniques are sufficient to provide us with lists of stocks that are likely to outperform the market -- on average and over the long term. We know how to achieve a good batting average in stock-picking. So, the principal role of the analyst, it seems to me, is to increase the level of comfort and the sense of control, both for the portfolio manager and the client.

This requires avoiding bad surprises from stocks that are either intolerably vulnerable to bankruptcy or priced for unrealistically high expectations. It also involves looking for possible good surprises among stocks where the expectations are extremely low and poor recent results have artificially depressed the income statement or balance sheet figures against which prices are measured. Conceivably, therefore, the net result of the analyst’s efforts may be to lower the long-term return of a portfolio slightly, but hopefully in exchange for a more stable, more comfortable, yet still superior portfolio performance.

Success in these endeavors requires two sets of skills.

The Overlooked Balance Sheet

One skill that is essential to anticipate potential surprises is an in-depth understanding of corporate accounting and the articulation between the various financial statements.

Martin Whitman, one of Wall Street’s sages, has frequently complained about the “primacy of the income statement” over the balance sheet in financial analysis today, as well as about analysts’ tendency to take for granted that a single figure, such as earnings per share, can express the whole truth about a company. Corporate managements, of course, encourage the current focus on reported earnings because, over relatively short periods, those are easier to “manage” than the assets and liabilities listed on the balance sheet.

Looking out for potential surprises, therefore, analysts should spend less time forecasting earnings, and more time looking for anomalies or discrepancies between the income and cash flow statements on the one hand and the balance sheet on the other.

In addition, the balance sheet provides a wealth of information about a company’s strength and resiliency. It is particularly useful, for example, to assess not only the company’s ultimate solvability, but also its liquidity and access to capital – e.g. how it might weather a recession, higher interest rates, and other kinds of external shocks.

Finally, most great investors profess, as I believe, that one can learn more about companies’ management from financial statements than from frequent interviews with CEOs or CFOs. For example:

·        Excessively large assets in relation to income, rather than a sign of strength, may indicate a lack of the skills necessary to transform assets into income and cash flow -- as was long the case in Japan, for example. After all, what are corporate assets for, if not to generate earnings or cash flow – either through more efficient management of operations or through asset sales, redeployment, etc.?

·        Very large goodwill may indicate a tendency to overpay for acquisitions, leading to later write-offs that should be scrutinized, especially when they are so frequent as to no longer be considered as “non-recurring” charges (even though that’s how they are categorized in the financial statements).

Contrarian Opportunities

I do not advocate applying one’s contrarian skills to the selection of individual stocks for two reasons:

One is that value investing is contrarian enough and, because it involves a thorough, critical analysis of a company’s financials, it also lowers the risk of overlooking a company-specific problem.

Another reason is that a contrarian bias is most useful in identifying investment opportunities when applied to economies, overall markets, selected industries or asset categories. Perhaps this is so because the crowds making up the consensus in these areas are larger and their sentiments are more broadly reported (and reinforced) by the media; one thus can feel surer of being truly contrarian.

[In terms of selling, a contrarian approach is useful, but not very precise. Stocks in the middle of a strong uptrend develop a price momentum that usually carries them to levels beyond any reasonable measure of “value”. This is why contrarians and value investors tend to sell well before the ultimate highs. But I believe it was Baron de Rothschild who claimed that the secret to his investment success was that he “sold too early”.]

One of the reasons why the contrarian approach is a good complement to the value approach on the buy side is that there are times when whole industries (or economies) have very depressed earnings after going through several years of adverse conditions. In some cases this may also have eroded asset values (buildings that command lower rents; mines that are unprofitable below a certain metal price; plants that may have had to be closed and written off). When this happens, strict value investing screens may not identify companies in these industries as value investments. If one believes that the causes of the recent travails are essentially cyclical, one must therefore make a leap of faith in guessing what the earnings and cash flow power of companies could be under more favorable conditions, in the next cycle.

One recent example was the oil and metal producers. Several years ago, with low commodity prices, earnings and cash flows were depressed, so that mechanical ratios did not point to undervaluation. Yet, with commodity prices recovering, many companies in these industries later achieved levels of profit margins that most observers then had thought impossible. They are now market and media favorites, with profitability that may not be sustainable over the long term and thus possibly in the zone where it is prudent to “sell too early”.

How to Be a Contrarian

Contrarian investing is not a science. Even more than other investment approaches, it is more of an art relying on a large dose of intuitive perceptions. The analyst’s first task is to identify overwhelmingly broad consensuses, by looking at a number of sources:

·        Market Underperformance. Looking for new investment opportunities, one source of contrarian ideas is a long period of market underperformance by a given type of asset (stocks, bonds, commodities). It usually takes two to several years of poor performance for the historical holders of an asset to entirely sell it out of their portfolios and to be replaced by new investors that carry no emotional baggage. Furthermore, as a trend ages, investors with shorter-term time horizons (such as hedge fund short-sellers) also tend to jump on the selling bandwagon, pushing prices to extreme lows. Even then, prices do not always recover immediately, however, and the asset group may, for a time, linger in the no-man’s land of universal neglect.

·        Headlines. Toward the final stages of a major downtrend, there usually is a proliferation of negative headlines which tend to sensationalize the trend, making it seem as if it is just happening whereas it may already be two or three years old. This is what is routinely called the “Business Week” effect: this otherwise excellent magazine is reputed to periodically devote its front cover to the devastation brought about by a major trend, just as that trend is on the verge of reversing.

Stubbornly poor market performance and the proliferation of sensationally negative headlines, of course, reinforce each other, spreading the consensus further and further abroad. This is why good complements to these two indicators are the “opinions” freely offered by cocktail party chatterers, barbers and apartment-building doormen.

·        Experts. It takes a wealth of historical data and months, if not years, of work for serious academics to study an economic trend, and then to articulate a scenario and write a book around it. This is why, especially when a number of books are published that forecast the prolongation of an aging trend, one should take this as a good contrarian indicator.

Note that we seldom hear about most academic studies, so that broad media coverage of an erudite book is not materially different from the headline phenomenon described above. In addition, in a promotional effort, the authors of such books are encouraged to write newspaper or magazine editorials, or to appear on TV programs that will entice the public to purchase their books. Beware of the experts that come into the limelight!

So, the more we hear about a long-established trend, the better the time for investors to take a contrarian stance.

Unfortunately, at that stage, a contrarian opinion will always seem less well researched and less clearly articulated than the prevailing consensus. In fact, it is more likely to sound like oft-discarded adages such as “trees don’t grow to the sky” or “every cloud has a silver lining”. This is why it is useful for the analyst who suspects the presence of a contrarian opportunity to adopt a very definite bias. This is done by looking, among the news, for “straws in the wind” that seem to contradict the prevailing consensus, and then to collect and accumulate them until they collectively begin to form the backbone of a contrarian scenario.

* * *

Contrarian thinking without fundamental analysis can be a minefield, akin to uninformed, “seat of the pants” trading. Furthermore, without a strong, fundamentally-based conviction about a company’s ability to survive and eventually recover, one’s contrarian attitude is likely to be eroded by the continuing flow of adverse news and “expert” opinions.

The combination of contrarian and value investing, however, holds the promise of being a winning formula. But, to succeed in applying this formula, financial analysts need to focus less on the continuity of companies’ operations and more on the potential surprises and discontinuities in their future.

François Sicart

April 9, 2005

© Tocqueville Asset Management L.P.