Why Are These WALL STREET Corporate Prophets So Often False?
By Conrad de Aenlle
September 14, 1991 NYTIMES

WEEK in and week out, brokerage houses publish diligently researched reports in which their highly paid, highly respected analysts estimate, sometimes down to the penny, what the companies they follow will earn in a given period. One of these reports, which can read like truncated doctoral dissertations, might explain in gruesome detail, and without the slightest hint of doubt, why Amalgamated Paper Clip, say, will earn $4.38 per share this year.

Investors, impressed by the painstaking effort and seemingly sound reasoning that went into that estimate, will call their brokers and snap up as many shares of Amalgamated as they can. Then a few weeks or months later, Amalgamated announces that a secular trend toward holding papers together with staples and glue has depressed sales and cut margins to the bone. Or maybe businesses are thinking green and trying to save trees by using less paper, and so they're buying fewer clips. In any event, the company earned only 3 cents a share, and when it discloses the grim fact, the stock falls 25 percent in minutes.

Most real-life miscalculations aren't that disastrous, and there are also some pleasant surprises, of course. Still, looking back over the last decade, earnings estimates for the Standard & Poor's 500, made one year in advance and constructed from forecasts for the individual companies, were 12 percent too high, on average, according to the Institutional Brokers Estimate System, which keeps track of earnings projections. The reason, argue some market observers, is that analysts are just too hopeful by nature.

"The only thing you can say is analysts, as a group, are an optimistic breed," said Rick Pucci, a vice president at IBES. But as time passes, they apparently begin to face facts.

"In 10 of the 12 past years," Mr. Pucci said, "analysts' aggregate estimates for the S&P 500 have started high and slowly been pared as the year went along." The exceptions were 1979, when earnings were pushed higher by ballooning inflation, and 1988, when forecasts were subdued by recession fears inspired by the stock market collapse of the previous October.

The IBES consensus for next year is that earnings for the S&P 500 will rise 27.8 percent. That's higher than the projections for the other industrial nations that make up the Group of Seven, except Canada. Canadian earnings are forecast to grow 50.9 percent in 1992, a spectacular recovery from an estimated fall this year of 11.6 percent. The smallest growth among the G-7 next year is expected in Japan, at 5.7 percent.

Paul Melton, editor of The Outside Analyst, agrees that analysts are an optimistic bunch, but credits nurture more than nature. Since most work for brokers, he said, "they can't place shares if they're too negative. The analysts' function is in the service of sales."

Keith Brown, director of European research for Morgan Stanley in London, disagrees. He asserted that financial service firms keep their research departments as disconnected from the brokerage end of the business as possible.

"They have to remain entirely separate and don't know what the other side is doing," he said.

Mr. Brown attributed the analysts' optimism to youthful exuberance, more than anything else. Many financial analysts are young enough never to have worked through a protracted bear market. It's easy to see why they would expect strong performance from the companies they follow; it's the only kind of performance many of them have had in years.

If American earnings forecasts leave much to be desired, they are still far superior to what's available elsewhere, Mr. Brown said, because research for the American market, flawed though it is, is more extensive than for any other.

While American companies report results quarterly, some European businesses report just semiannually and others only annually, he noted. And European reports tend to disclose less information, and to disclose it much longer after the fact. Accounting methods outside the United States are often less reliable, as well, he said, and that can taint earnings estimates.

Mr. Brown said he would trust Spanish and British projections more than Swiss and German ones.

"The U.K. has a good deal more disclosure," he said, adding that this made it much easier to figure out what is happening at a company.

Mr. Melton agreed that "you can rely on the estimates in the United States much more than elsewhere. If you're looking for haute cuisine and want something to surprise your palate, you don't go to McDonald's, but if you want a reliable hamburger. . . ."

He added that investors can filter out excessive analytical optimism, wherever it may be found, if they "check out the macroeconomics" and examine forecasts in the context of the economy.

Economists are pessimistic sorts, the antithesis of financial analysts, he said; such a somber way of looking at things can be used to keep the financial analysts' forecasts tethered not too far off the ground.

Hugh Johnson, chief economist at First Albany Corp., conceded that practitioners of his art can be a morose lot.

"I think there's probably some truth to that," he said. "Economists are trained to be very careful and not to become in any way emotional, euphoric, upbeat, happy in anything you forecast. You're trained to be sober, accurate and precise."

He added: "They tend to be very quantitative. A quantitative approach to anything can be laborious, tiring. It can turn the happiest of souls into the most lugubrious of people. The other side of it is there is always something wrong. You can always find ammunition for a restrained view."

But he added, "In the defense of analysts and economists, the world is essentially unpredictable."

One of the problems analysts face is they must base their forecasts in large part on what information they are given, and that may not be accurate or up to date.

"Analysts talk to people at the top, and bad news travels up the corporate ladder very slowly," Mr. Pucci pointed out. "A good analyst is going to try to verify information he receives from the company from other sources. He may know about problems before management does." And he may not.

"Most financial analysts are making minor adjustments to what the companies tell them is going to happen," Mr. Johnson said. "You very seldom find analysts that are brave enough to make big departures from the company script."

When a company's trouble can no longer be hidden, "analysts have to make instantaneous changes," he said.

Mr. Pucci advised that investors do their own research. "If you walk by a factory and see them putting an extension on, go and talk to somebody who works there," he said. "You may know more than the analyst on Wall Street." He argued that investors who are not prepared to put in such an effort would do better to buy a fund and not an individual stock.

The best way to use analysts' estimates, he said, is "to find the people on opposite ends of the seesaw, run them through your mind and decide which makes the most sense."

Mr. Brown urged against relying heavily on estimates: "In the U.S. there is a lot of emphasis put on numbers and forecasts. In Europe, because of the levels of disclosure, levels of information, the figures are not the be all and end all of everything."

He advised taking the long view, and Mr. Johnson agreed.

"You try to preserve some perspective," he said, "and try to realize that over much longer periods of time, the economy has been growing with stops and starts" and "stocks have been rising with stops and starts."

But he conceded that "it's a very-short-term-oriented investment community" and that analysts will continue trying to divine next year's earnings.

"Enormous resources are being wasted on all of this," he said. "We pay a lot of people a lot of money to do something that isn't all that valuable."