Usefulness of Company Analysis

Last week, I wrote about market commentary. I find it distracting to read anything that tries to predict where the markets are going or even that tries to explain why the markets are moving as they are. There is not always an explanation for the repeated quick interactions between thousands of emotional human beings. The answer to “why did a stock go down just now?” could be as simple as “it’s not very liquid and an individual somewhere needed cash.” Market commentary should be viewed with a large grain of salt, if at all.

What analysts are good at, however, is understanding the quality of businesses. Even if they can’t predict market prices (think of fluctuating P/Es, as an example), analysts can tell whether or not a company is financially strong and well managed. Reading an analyst report can be helpful in understanding a business, how it generates revenue, its level of profitability and the professionalism of management. Often, it will also include risks that an investor should beware. However, analyst reports seem to always include target prices and expected returns. It can be funny to look back over the past and review analyst reports from a couple years ago because target prices and returns are probably wrong more often than right.

The reason that analysts can’t predict future stock prices is that there are too many variables that interact in unpredictable ways. The analyst begins by predicting future earnings. I have not been trained as a stock analyst, but there are only two ways I can think of to do this. First, by extrapolating current and past earnings along a straight line. That is to say, use the current earnings growth to predict future earnings growth. This might work, except when a recession, or other negative event, arrives unexpectedly. The second method involves trying to adjust the earnings for future events, like an economic recovery, a takeover offer or a labour dispute. The problem with this method is that, even if the predicted events take place, the magnitude and timing of their affect is unlikely to be as expected.

Where fundamental company analysis can be helpful is in comparing two companies for relative strength. As an example, an analyst may look at two banks. Ignoring future earnings and future market movements, the analyst can compare current profitability, indebtedness and the quality of management to form a judgment of which company is relatively stronger. Investing in relatively stronger companies won’t avoid market turmoil, but it should provide a relatively good return over long periods of time. As an aside, this is how the first hedge fund arose; the “hedging” was pairs trading, buying strong companies while selling short weak ones. The difference in growth became the return, while hedging away market fluctuations.

When I write about stocks as an “investment idea”, my purpose is to look at the quality of the company. I try to find whether or not the stock is priced attractively in the market compared to the past. I try to see whether the earnings have been consistent and whether or not management is capable. I find the debt level to try and determine the risks. I don’t claim to know whether or not the price of a stock will rise or fall in the future, since I view that as unknowable. This explains why I prefer stocks that pay a dividend: it makes one aspect of the total return more predictable.

extent of riskiness.