Analysts Cut Earnings Forecasts, Embarrassingly Late

Friday, 13 Jul 2012 07:42 AM

 

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Mid-year profit warnings in northern Europe have wrong-footed equity analysts who forecast strong earnings despite a global economic slowdown — the latest embarrassment for a profession whose own value many investors now question.

Thomson Reuters data show average analysts' forecasts for earnings growth in Germany, the Netherlands, Switzerland, Sweden, Norway and Belgium were broadly stable, or even raised, in the first half of the year.

Yet in that time there was no shortage of evidence of global slowdown, from China and the struggling euro states of southern Europe to business sentiment surveys even from the likes of Germany. Sure enough, among the mid-year updates from companies, a raft of profit warnings has disappointed investors who took the advice of bullish analysts and have seen share prices drop.

Many analysts are now revising estimates downwards, but for some clients the damage is done. Many see it as undermining — again — the entire case for brokers employing research analysts at all and question their objectivity. Analysts themselves say, however — and many fund managers agree — that the value of their work is far from confined to profit and share price forecasts.

They do not lack critics, however: "They're not very valuable," said fund manager Michael MacPhee at Baillie Gifford.

"Human beings are incredibly bad at forecasting anything," he said, adding that he and colleagues rarely saw any point in even speaking to analysts at investment banks.

For some, forecasting has little more credibility than aimlessly throwing darts at a board. Unsurprisingly, Peter Steiner, analyst at BHF-Bank in Frankfurt, disagrees. His forecasting has a clear empirical basis, he says.

Like most of his counterparts, he constructs computer models of the businesses he covers. These formulae-filled spreadsheets attempt to capture the variables, such as commodity prices and interest rates, which determine a company's profits. Steiner constantly updates the variables in the model to reflect changing circumstances, thereby refining his forecasts.

Critics, however, say that many analysts seem actually more influenced by nods and winks from investor relations departments — to whom analysts usually send their research notes before publishing them — than the answers thrown out by their models.

The narrow deviation in analysts’ forecasts around the average or consensus level is often seen as proof of this, and the result can be that forecasts fail to get ahead of market data as analysts wait for managers to tell them of the impact on their businesses of wider economic trends visible earlier.

Recent experience may show the problems of relying too much on what companies say.

Steiner and his peers were caught out by a newspaper interview on July 8 in which Olaf Koch, Chief Executive of German supermarket giant Metro AG, indicated the euro zone crisis would hit profits harder than expected.

In line with other analysts, Steiner then cut his price target following the interview, to 29 euros per share from 36 euros. However, by that time, the share price had already fallen over 5 percent to around 20 euros a share.

Had the analysts foreseen the weakening of profits, which a reading of economic data from Metro's European markets might have helped predict, then they might have cut forecasts a week earlier and their clients could have netted big profits.

Similarly, analysts were surprised on June 26, when German chipmaker Infineon lowered its sales and margin outlook, less than two months after it raised its sales outlook.

And on the same day, steelmaker Salzgitter said profits would fall sharply this year. Just six weeks earlier, on May 15, the German firm had said it expected stable profit in 2012.

Slow To Disappoint

But fund manager David Hussey, head of European equities at Manulife Asset Management, was sympathetic to the analysts' plight and said it is wrong to criticize sluggish forecasts when managers remain bullish in the face of deteriorating conditions.

"That's the companies' fault," he said. Investors say managements in Europe can be slow to deliver bad news. On Tuesday, Zurich's stock exchange fined hearing-aid maker Sonova for a tardy release of a profit warning.

Companies think much of the criticism is harsh. Spokesman Christian Hoenicke said Infineon's outlook cut was due to a rapidly deteriorating market. Bernhard Kleinermann, head of investor relations for Salzgitter, said the ebbing demand for steel was also unforeseeable.

He blamed analysts themselves for having a bias toward rosier forecasts, especially when the economy was turning down and stock markets falling across the board. "Analysts tend to be very optimistic because they want to sell the shares," he said.

American and British firms may be prompter in delivering bad news, some investment managers say — if so, that may partly explain why the Thomson Reuters data showed forecast earnings growth for British companies being slashed between January and July, as sterling appreciated in its euro zone export market.

Missing The Point

Concentrating on their forecasting performance may be to miss the point of brokers' analysts. Few fund managers admit to basing investment decisions on the forecasts anyway, and some rate highly the depth of insight specialist analysts can offer.

"(Forecasting) is not why we use analysts," said Joost de Graaf, Senior Portfolio Manager at Kempen Capital Management in Amsterdam.

"For us, it is more to understand the business model of a company, for example, to know if it is making the right capital allocation decisions, what its competitive advantage is."

Indeed, the whole equity research business model is shifting towards phone calls and face-to-face meetings with investor clients, and away from a traditional focus on research notes, models and forecasts, people across the business say.

Hedge fund managers are more interested in using analysts to test and or refine their own investment ideas, than in slavishly following cues in research reports which can be out of date as soon as they have been approved by a bank's compliance unit.

Analysts are increasingly rewarded for the number of meetings they asked to attend by investor clients of the bank they work for. Rewards for the bank in turn, can come from clients then placing orders with the firm's traders.

Certainly, however this year's European forecasts turn out, there is no sign of banks giving up on employing teams of equity analysts.

For fund manager de Graaf at Kempen, that is no surprise: "Most of the analysts have good opinions," he said. "And that for us is far more valuable than their earnings forecasts."

© 2014 Thomson/Reuters. All rights reserved.

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