Analyzing the Analysts


The most important information in the financial analysts' reports is the change in their estimates and not the actual recommendation or the level of the estimated future earnings.

Although there are notable exceptions, analysts’ recommendations in aggregate create little or no excess return. This is according to a number of academic studies carried out in this area.

The inability to predict share prices reflect several factors. First of all, it is incredibly difficult to predict the future of the stock market.

Secondly, in some cases, the analysts are inhibited by conflicts of interest in their work. In the brokerage industry, which increasingly feeds on corporate finance income, it might not be very street smart for analysts to issue sell recommendations on key corporate finance clients.

Stronger walls

So far, it has been tried to shield analysts from such conflicts of interest by establishing "Chinese walls". However, flimsy Chinese paper walls are not always robust enough to withstand the economic laws of gravity in the brokerage industry.

This is why the EU is now launching the MiFID II Directive. Instead of getting analysis for free as a “package deal”, customers will have to pay separately from 2018. The aim is to make the analysts' economic incentives fully in line with their customers.

This winter in Dovre we have carried out a comprehensive analysis of analysts' recommendations and estimates. We have collected large amounts of data from Bloomberg which we then dissected in statistics programs.

Follow estimates changes

The conclusion is that neither the analysts’ recommendations nor the levels of the estimated future earnings are important. Rather it is money to be made by following the changes in earnings estimates.

Companies, where the consensus estimates have recently been revised up, tend to outperform the market and vice versa.

Here is an example of such a strategy: The 25 companies included in the Oslo Stock Exchange OBX index are ranked according to four weeks change in 12-month forward consensus EPS and then divided in the middle into two portfolios, which are rebalanced daily.

The last decade the portfolio consisting of stocks from the top half, that had the largest percentage positive EPS revisions in last four weeks, yielded a return of 221 percent, while the return for the bottom half is -45 percent. For comparison, the OBX index was up 93 percent over the same period.

If this exercise was repeated for the 30 largest companies listed on the Stockholm Stock Exchange, one would obtain similar results.

Frontline estimate winner

Which stocks have the best and worst EPS momentum right now? Out of the OBX companies – Frontline takes the throne with an increase in the estimates of ten percent over the past month. Then follow PGS and Opera with upward adjustments of respectively nine and four percent.

However, we recommend taking PGS with a pinch of salt, because earnings estimates are close to zero. In this case, even the slightest nominal changes bring large percentage fluctuations.

On the negative side it is not surprising to see oil service companies. TGS estimates are down drastically 46 per cent last month, while Subsea 7 and Seadrill have shaved their earnings expectations with respectively eleven and eight percent.

This week we bet that estimate momentum will be followed by price momentum, and thus put Frontline into the portfolio.

Dovre portfolio:

  • Panoro Energy
  • Ganger Rolf
  • Selvaag Bolig
  • Biotec
  • Ekornes
  • Frontline

In: Frontline

Out: PGS