institutional vs. individual investment decisions

This is a follow-up to my post from yesterday on perils of relying on an analyst’s investment recommendations.

The FINRA article I mentioned in that post comments that institutional investment decisions can be motivated by considerations that differ markedly from those we as individuals face.

What does this mean?  Here are some examples:

1.  for almost two decades, endowments (like those for universities) have made large investments in highly illiquid “alternative” assets.  They argue that their financial circumstances allow them to take liquidity risk in search of extra-high returns because they won’t need the money for, say, 25 years.

Such investments present several problems for you and me:

generally speaking, endowments haven’t cashed out of many of these investments, so it’s not clear how well they’ve done

we probably don’t have a 20-year+ investment time frame, and

we definitely will only be able to participate in alternatives on much less favorable terms than big institutions.  In retail-oriented projects, the organizers reap most of the rewards.

2.  An institution may try to offset the risk of “roll-the-dice” investments by being very conservative in other areas.  Without knowing its overall investment strategy, it’s hard to know how to evaluate any one part.  So when an institutional portfolio manager says he has a huge weighting in Treasury securities, it may be that he’s acting on instructions from his client, or it may be to offset the risk of holding a ton of risky emerging markets debt.

3.  Portfolio management is a craft skill that sometimes operates on less-than-obvious rules.  The IT sector, for instance, is the largest component of the S&P 500, making up almost 20% of the index.  The largest constituents are Apple, Microsoft, IBM, Google,  and Intel.

Let’s say I’m a PM and I don’t like the IT sector right now.  I probably won’t express my opinion by having no technology stocks.  To make up a number, I may elect to have 15% of my portfolio in IT.  If I’m right, I’ll make gains by having the “missing” 5% invested in a better=performing sector.  I may also decide that, because I want to be defensive in this area, I’ll shift my emphasis toward the biggest, lowest-multiple, most mature companies.


But that’s the point.  These will probably go down the least in a bad market.

As a result, I may end up having 3% of my portfolio in AAPL and another 3% in MSFT.  They may also be the largest holdings in my portfolio.  A cursory glance at my holding may give the impression that I like AAPL and MSFT.  I do, but only in the sense that I expect that they’d go down–they’ll lose less than smaller IT stocks, gaining me outperformance.   They’re my hedging alternative to making an all-or-nothing bet against IT.

Another situation:  let’s say I have no clue how AAPL will perform.  I may decide that I should concentrate my attention elsewhere in the portfolio, where (I hope) I can add value.  The easiest–and safest–thing I can do with AAPL is to neutralize it.  That is, I hold the market weight in the stock.  Yes, I won’t gain any outperformance this way, but I won’t lose any, either.  Because AAPL is the largest stock in the S&P 500, AAPL may end up being my largest position.  But, again, this doesn’t mean I like it.  It means I don’t want the stock to hurt me.

Will I explain any of this in an interview?  Yes, I’ll try.  But reporters’ eyes will glaze over.  What they’ll come away with is the idea they came in with–that my largest positions must be my favorites, and they’re AAPL and MSFT.




the FINRA Guide to Understanding Analysts’ Recommendations

Yesterday someone sent me a link to Understanding Securities Analyst Recommendations, written by the Financial Industry Regulatory Authority (FINRA), the brokerage industry trade organization.

The short article is surprisingly candid and contains important information, although couched in very abstract language.

The highlights (paraphrased by me):

–brokerage house analysts, and the brokerage houses themselves, are subject to enormous potential conflicts of interest when it come s to saying what they think the future performance of a given stock may be.  For instance, –a company may select a brokerage house for lucrative investment banking business based on how favorably the firm rates its stock

–conversely, it may refuse to give corporate information to analysts who rate the stock unfavorably.  The company may “forget” to return phone calls, avoid appearing at conferences sponsored by the analyst, refuse to appear with the analyst at public or private investor meetings, or not acknowledge requests for information from institutional investors that are directed through the offending analyst.  The company may even more overtly try to get the analyst fired.

–very large money management companies may build up gigantic positions in the stock of a given company.  Powerful portfolio managers may have large stakes riding on the stock’s performance–and the positions may well be too big to sell quickly, in any event.  So they may pressure brokers and their analysts to maintain a favorable opinion on the stock.  Their threat–to withhold trading commissions from a firm that downgrades the stock.  Same thing about firing the analyst, too.

–as a result, the terms brokers use to rate stocks may not be self-evident.  “Buy,” for example. may not be a particularly good rating.  “Strong Buy” or “Conviction Buy” may be what we’d ordinarily understand as”buy.”  “Buy” may be closer to “Eh” or “Hold.”  Of course, analysts may also have one official opinion in writing and another that it expresses verbally to clients.

Two other worthwhile points the article makes:

–some analysts may not be highly skilled, so their recommendation may not be worth much.  Rookies may not have enough experience, for instance, and they may be more susceptible to outside pressure than others.  Analysts may not know a spreadsheet from a hole in the ground but have the ear of management.  (Oddly, old-fashioned managements continue to give information to favored analysts that they deny to shareholders.)

–the fact that a portfolio manager owns a stocks, even if it’s a large position and if his analyst appears on TV saying positive things about it, the manager may hold the stock for completely different reasons (more on this tomorrow). Anyway, the FINRA page is well worth reading.

why does Wall Street care about sales gains and not just earnings gains?

…after all, what ultimately matters is how much profit a company’s management is making for its shareholders, isn’t it?

Yes, and no.

two special cases

Let’s deal with two special cases before getting to the main topic.

–Investors who focus a lot of their attention on startups that are not yet making money will typically use sales growth as their major metric.  There are no profits yet.

–Value investors will be drawn to mature companies with lots of sales and little or no earnings because of their turnaround potential.  This is especially true if they can see other firms in the same industry who are comfortably profitable with similar levels of sales.

Neither is an example of the phenomenon we are now seeing as some companies report 3Q12 results.

strong earnings, weak sales

When earnings meet/beat the consensus estimates of brokerage house analysts–and sales don’t, the stock in question often goes down, sometimes by a lot.


it’s all about recurring earnings

1.  Investors typically look for recurring gains when they buy stocks, not one-off profits.

Consider this oversimplified example:

A company reports earnings per share of $1 for the current quarter.  If you know that this is all the profit the firm will ever make, then–assets (if any) aside–you won’t pay more than $1 for a share of stock.  (In fact, you’d probably pay less, since the $1 of profits is in the hands of management, not in yours.)

On the other hand, if you thought the company would earn $1/share every three months for the next ten years, you could be willing to pay up to $40 for a share of stock.

So there’s a huge difference between the value to investors of recurring and non-recurring profits.

2.  If a company reports higher earnings without what analysts consider an appropriate increase in sales, investors assume that the firm has achieved its profit target through cost-cutting of some type.  They argue, correctly in most cases, that the profit increase isn’t sustainable.

More than that, they view the slower sales increase as a leading indicator of slowing profit growth that will emerge in subsequent quarters.  They can see the train coming at them, as it were, so they don’t wait to get off the track.  They sell now.

Their picture is this:

Suppose the company has been spending $1 million a quarter on marketing up until now, but cuts the budget to $500,000 for the just-reported quarter.  That produces just enough extra margin that the company reports $1/share in earnings instead of $.90, thus meeting consensus eps expectations.

The worst case is that the reduced marketing is a mistake that will negatively affect sales and profits in coming quarters.  But even in the best case–that this is a true savings–the company can only cut marketing expense once.  

Yes, the company will also report an extra $.10 in eps for the next three quarters.  But that’s it.  This is really no longer a company earning $1 a share per quarter for as far as the eye can see.  It’s a company that’s earning $.90 a quarter + a non-recurring $.10 now and for the next three reports.

If you were previously willing to pay $40 for $1 a share in quarterly earnings, you should (at most) pay $36 for $.90 a quarter profits.  Add (at most) $.40 for the non-recurring earnings.

The main point is that cost-cutting has to end relatively quickly–and should not be mistaken for a permanent element of a company’s profitability.

3.  Some managements won’t be inclined to call attention to this information and will just show it somewhere in the financials (in the hope analysts won’t bother to read the fine print).  The cost-cutting could also be a bunch of little things, significant in the aggregate but not big enough individually to require disclosure.   If so, the slowdown in sales is the only clue to what’s really going on.

4.  For multi-line companies, the situation isn’t so simple. Sometimes, a firm may be phasing out a line of business where it earnings little or no profit, so it’s sales growth sags while profits advance smartly.  Here, “Shoot first, ask questions later,” may be the wrong strategy.  But it’s what short-term traders always do.  And, in my experience, “Shoot first…” is right more often than not.

reason six why analysts mis-estimate company earnings

reason #6

In my post from yesterday, I titled this reason “making dumb mistakes.”  I’m not sure what else to call it.  Let me illustrate with two examples of recent huge misses by analysts who should have known better.  They’re the June quarter results from two high-profile companies with plenty of Wall Street coverage, WYNN and AAPL.

Let’s take WYNN first.

WYNN’s 1Q2011

In 1Q2011, WYNN earned $173.8 million, or $1.39 per fully-diluted share.  Look one line higher on the income statement, and you see that the $173.8 million figure is after deducting $52.5 million in “income attributable to non-controlling interests.”  That’s minority interest.  It’s income that belongs to the 27.7% of Wynn Macau that WYNN doesn’t own.  (Wynn prepares its financials as if it owned 100% of Wynn Macau, and then subtracts out the minority interest at the end.)

From the minority interest figure and the magic of long division, you can calculate ($52.5 /.277) that Wynn Macau’s total net income was $190 million. WYNN’s share was $137 million.  Therefore, WYNN, ex its interest in Wynn Macau, earned $36.8 million for the quarter.

One unusual feature of 1Q11:  gamblers at the WYNN tables in Las Vegas had bad luck by historic standards during the quarter.  They lost a bit over 30% of what they wagered vs. historical loss experience of 21%-24%.

Any analyst who follows the company could have found all this out in five minutes of studying the 1Q11 income statement.  Given that the analysts’ consensus for 1Q11 was wildly low at $.73, you’d assume they’d do so to try to figure out where they went so wrong.

turning to 2Q11

In 1Q11, 80% of WYNN’s income came from fast-growing Macau, 20% from slowly-recovering Las Vegas.

From figures the Macau government posts monthly on its Gambling Coordination and Inspection Bureau website, we knew on July 1st that gambling revenue for the market as a whole was 12% higher in 2Q11 than in 1Q11.  If we assume that Wynn Macau grew in line with the market, and that a 12% increase in revenues produced an 18% jump in income (basically, adjusting for normal operating leverage and the fact that Wynn Macau “adds” gambling capacity by raising table stakes), then Wynn Macau would have earned about $225 million in 2Q11.  Of that, WYNN’s share would be about $165 million.  That translates into around $1.35 a share for WYNN in eps during the quarter.

What about Las Vegas?  It chipped in $.25 a share to first quarter earnings.  “Luck” at table games returning to historical norms would probably push that figure back to zero.  On the other hand, room rates at both Wynn and the Encore are gradually rising, so zero might be too low.  But let’s stick with zero from Las Vegas is the most reasonable guess.

In other words, a sensible back-of-the-envelope guess for WYNN’s eps in 2Q11 would be $1.35 + $.00  =  $1.35.  This isn’t necessarily the most conservative forecast, but it is one based on factual data about the Macau gambling market and the assumption that nothing much goes wrong (or right) in Las Vegas.

What did the professional analysts say?

The median estimate was $1.01.  The highest was $1.25; one analyst had the dubious distinction of saying eps would be $.69.  For this last estimate to have come true, WYNN would have had to break even in Las Vegas (it earned about $.25/share) and to have revenues in Macau drop by 25% quarter on quarter, while the market was growing at 12%.

Given that WYNN’s results are so strongly influenced by Macau, even the median was predicting a relative disaster for the company there.  What were they thinking?

(True, they might have been assuming a disaster in Las Vegas, not Macau.  And, I’ll admit, I thought WYNN has done surprisingly well in Las Vegas so far this year.  But Las Vegas isn’t big enough to move the eps needle down to $1.  And the situation is a little more complicated than I sketched out above:  Wynn Macau pays a large management and royalty fee to the parent, almost $40 million in 2Q, so the better Macau does, the better ex Macau looks.)


AAPL’s 2Q11 (ended in March)

During 2Q11, AAPL earned a profit of $6.40 a share.  Its business broke out as follows:

Macs     3.76 million units     $4.98 billion in revenue

iPod      9.02 million units     $3.23 billion (includes iTunes)

iPhone     18.6 million units     $12.3 billion

iPad     4.7 million units     $2.84 billion

Other                                         $1.3 billion

Total                   $24.7 billion

turning to 3Q11

Let’s try a back-of-the-envelope forecast for AAPL’s 3Q11.  To make things ultra-simple, we’ll ignore operating leverage, which will bias our estimate to the low side.

Macs  growing, but slowly in a developing world where overall PC sales are flattish.  Let’s say $5 billion in sales.

iPod  flat, $3.2 billion in sales

iPhone     industrywide smartphone unit sales are growing at 80% year on year.  All the growth is coming from half the market, Android and iPhone, with Android growing faster; Nokia and RIM are taking on water and sinking fast.  Let’s pencil in 19 million units at $660 each = $12.5 billion.

iPad  this is the tricky one.  We know that AAPL is capacity constrained, is adding manufacturing capacity as fast as it can, and sold 4.7 million units in 2Q11.  Let’s put in 6 million units at $600 each, the average price from 2Q11.   That’s $3.6 billion.

Other Leave it flat at $1.3 billion.

Add all these numbers up, and we get $25.6 billion.  If we assume constant margins–i.e., no operating leverage (which a really terrible example to set–working with margins instead of unit costs, but I’ll do it anyway), then earnings will come in at $6.60-$6.75 a share for the quarter.

As events turned out, my guess is way too low.    …oh well!   AAPL reported eps of $7.79.  The big difference?  The iPad sold 9.2 million units and brought in $6 billion in revenue.  That alone adds more than $.60 a share in earnings.  The rest is bits and pieces.

So I missed badly.  That’s not really the point.  The real question is how my ten-minute approach stacks up against the work of the 45 professional analysts who follow the company for a living–and for whom AAPL is probably their most important stock.  Check them out and I’m starting to look pretty good.

the analysts

The median estimate of the 45 was $5.82 a share.  The low was $5.10, the high $6.58.

How could they consensus be projecting an almost 10% quarter on quarter drop in earnings?

APPL’s main business, smartphones, which accounts for 50% of total company revenue, and a higher proportion of profit, is exploding. The category is growing by 80%.  Rivals NOK and RIMM are not only going nowhere, they’re getting worse by the day.   In fact, NOK’s smartphone sales in the June quarter fell year on year–probably by a third. So AAPL’s continually taking market share from them.  Quarter on quarter sales were likely up.

We don’t know what 2Q11 iPad revenues could have been, only that they flew off the shelves as fast as AAPL put them on.  So product sales had to be up, maybe substantially, in 3Q11.

If both iPhone and iPad were flat, quarter on quarter, the only way to get company results to be down 10% would be if Mac sales, which represent about a fifth of the company’s business, were cut in half.  Hard to fathom, given that the PC industry is growing, if only slightly, and Macs have been gaining significant market share from Windows-based PCs.

what did I do differently?

I think everybody ignored AAPL’s “guidance” of $5.03.  WYNN doesn’t give guidance.

I did five things:

I gathered industry information from the internet.

I read the prior-quarter results carefully.

I used a line of business table to make (very primitive) quarter on quarter projections.

I ignored macroeconomic forecasts of slow growth for the US, since both firms target the affluent here–AAPL more so than WYNN, I think.

I didn’t worry about missing on the high side.  I didn’t want an estimate that was deliberately too conservative.

What didn’t the analysts do?

I only have guesses.

It’s possible that they were influenced by downbeat general economic news.  Even so, I don’t see how you could have gotten to the consensus figures for either APPL or WYNN if you did a line of business table.  But that’s one of the first lessons in Security Analysis 101.  Maybe the analysts in question were out that day.

6 reasons why Wall Street analysts mis-estimate company earnings

companies continue to beat Wall Street estimates

It’s earnings season again.  As companies report their results for the quarter, investors watch carefully to see whether they match, surpass, or fall short of, the consensus estimates of Wall Street securities analysts.  As has been the case since the bull market began over two years ago, a majority of companies are beating the consensus figures–some by a mile .

Why don’t analysts do a better job of forecasting?   

I have six reasons (five of them today, the final one tomorrow):

1.  Some companies are very hard to forecast, because they’re so complex.  They may have a lot of divisions, many suppliers and a large variety of finished products that they sell.   

Alcoa, the first of the big publicly traded US corporations to report each quarter, is a case in point.  You’d think that the main variable for Alcoa would be the price of aluminum, which you can see every day in commodities trading.  …but no.

Alcoa can get its raw materials from many sources.   Some sources are joint ventures that Alcoa’s a part of, which often have complicated profit-sharing arrangements that are not publicly disclosed.

Miners deliberately change the grade of ore they mine, depending on price, to maximize the life of the ore body.  Ore can be processed in different locations, some company-owned, some not, depending on the price of electric power and other factors.  So expenses are hard to gauge.

On top of all that, differing accounting conventions at each step of the way can play a big role in what cost figures eventually appear on the income statement.

In a case like this, it’s hard to imagine anyone outside the company having a good handle on what reported earnings will be.

2.  Some companies demand that analysts stay close to “official” guidance.  CEOs understand that having earnings per share that exceed the consensus is a good thing for their company’s stock  (a positive earnings surprise), and that missing the consensus can be a very bad thing  (a negative surprise).  So most firms that issue next-quarter guidance to analysts give out numbers they believe they have an excellent chance of beating.

Some firms go further than that.  They make it clear they will punish any analyst who deviates from guidance more than a little bit.

What can a company do?

Lots of bad stuff.  From descending order from worst to not-as-bad, the company can:

–stop using the analyst’s firm for any investment banking services, like underwriting debt or equity offerings (which is likely to get the analyst fired),

–not appear at industry conferences the analyst’s firm may organize, or send the investor relations guy instead of the CEO or CFO,

–avoid using the analyst to organize the company’s visits to powerful investment management companies,

–refuse to give the analyst access to top company officers to ask questions about operations,

–delete the analyst from the queue to ask questions during earnings conference calls (petty, it’s true, but not unusual).

There have been cases of stubborn analysts who have stuck to their guns in print, against company wishes.  Their stories  usually end badly.  For most, they’ll show the number the company wants in their written reports and “whisper” their best guesses to clients.

3.  Some analysts aren’t good with numbers.  That’s not always a fatal flaw.  The analyst may have other pluses–a deep knowledge of the inner workings of an industry, an ability to  sense new trends quickly, or very good contacts with the companies, or customers and suppliers.  Or maybe they just know where to take clients to lunch.  After all, when you get down to it, sell-side analysts are paid for their ability to generate commission business  for their trading desks and to attract/keep investment banking clients–not necessarily for having the best numbers.

4.  Sometimes analysts don’t do the spreadsheets themselves.  An assistant does them instead.  Analysts may spend half their time on the road visiting companies and clients.  Much of the rest of the time, they’re doing the same thing on the phone.  And the analyst may not be so great with numbers, anyway.  So that task is relegated to an assistant.

An aside about assistants:  in my experience, many analysts pick assistants who are articulate, look good in a suit and are smart–but not too smart.  Why?  A sell-side analyst may earn 10x-20x what an assistant does, in an industry that suffers a severe downturn in profits about twice a decade.  The analyst may worry that having a top-notch assistant means the analyst becomes a cost-cutting victim during recession.

5.  Many experienced analysts have been laid off over the past few years.  Doing good estimates doesn’t require a genius, but it does require some training and experience.  A lot of that has been lost on the sell sidesince the Great Recession began.  In addition, as I suggested above, the assistants who have been promoted into the principal analyst jobs may not all be the brightest crayons.

That’s it for today.  I’ll write about #6, making really dumb mistakes, tomorrow.