When Crystal Balls Get Cloudy

Cover Story, by Mark Robertson, Managing Partner March 1st, 2016

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Do your best, but bear in mind that sometimes even your best efforts don’t deliver the desired results.

It’s not often that I set off to cover a subject with a set of assumptions that are steeped in common sense and intuition only to have them derailed. This month’s cover story does precisely that. In the words of our technology manager, Kurt Kowitz, “Huh? You mean that we should be shopping among the (40) worst — lowest return expectations — from the Goldman Sachs research reports in order to experience the best results?” I’m not ready to go there. Yet. Goldman Sachs is the 800-pound Rhino in the room and they do good work. The sample size is small but the results of their one-year forecasts from one year ago are disturbing.

“Do your best, but bear in mind that sometimes even your best efforts don’t deliver the desired results.” — Eraldo Benovac

“Results take time to measure.” — Hyrum W. Smith

During March 2015, we shared a list of (80) 1-year return forecasts from one of the most influential and respected research firms on The Street. The list was dubbed, “Stocks With The Most Upside & Downside To Goldman Sachs Target Prices (3/31/2015).” We featured the article in the Manifest Investing Forum and promised to check back in a year. The (40) stocks with the most “upside” included (39) buy ratings. The (40) stocks with the most “downside” included (22) sell ratings.

The (40) stocks with the most UPSIDE had a 1-year total return forecast of 28.8%. One year later, they collectively “checked in” at -5.7%, on average.

The (40) stocks with the most DOWNSIDE had a 1-year total return forecast of -19.0%. One year later, they collectively deliver an average total return of -1.7%.

I’ll let that sink in.

Yes, the (40) DOWNSIDE featured stocks beat the (40) UPSIDE “buy list” favorites by +4.0% — four percentage points or 400 basis points!

The Wilshire 5000 declined (-1.0%) from 3/31/2015 to 3/31/2016.

38.5% of the upside group beat the market. 47.5% of the downsiders topped the total stock market benchmarket for the year?

Oh … and that single UPSIDE stock with a neutral rating? FLIR Systems (FLIR) beat the market by +7.9%!

You can’t make this stuff up.

Eraldo, Hyrum & Kurt Are Right

One year is a short amount of time. Wall Street Rhinos seem to struggle mightily with smaller horizons. The sample size is relatively small. Even Mighty Casey struck out occasionally. We’d also note that we’re focusing on the flat ends of a bell curve, a “zone” where results are likely to be more erratic.

It’s a single sample over one time horizon and by definition, it’s anecdotal. But missing by 51.8% is at best, disturbing. It has been our premise that the 1-year total return forecasts — in combination with our fundamentally centered 5-year time horizon forecasts — could be an effective approach to culling opportunities. Start with a solid long-term perspective and use the shorter term broker recommendations as catalysts or tiebreakers. We scan the 1-year forecasts during each weekly update by checking inputs from Goldman Sachs, S&P, Merrill Lynch, J.P. Morgan and Morgan Stanley. These firms have long been the most influential on stock prices as shown by this narrative:

“I realize this is a piece of anecdotal evidence, but just recently a Goldman Sachs analyst added a stock to a conviction buy list. The stock immediately shot up 10%. Analysts at Goldman Sachs probably have more ability to move the market than others, and specific analysts may be more trusted by the market than others, but casual observation over the last year or two suggests at least a short term effect. Long term, I would hope that stocks would be valued more on their merits, but I imagine that’s an even more complex question to answer than the short term one.”

Therein may lie a counter intuitive reality. Our experience has been that 5-year time horizons are more reliable than what we’ve experienced from the 1-year and quarter-to-quarter variety. And THAT was before these results from Goldman. We also monitor and factor analyst consensus estimates and target prices … and will now gauge their potential superiority versus the most influential Rhinos.

Equity Analysts Are Still Too Bullish

Barry Ritholtz has documented in the past that analysts are not paid to make stock recommendations and a number of academic profiles make it clear that providing reliable forecasts for retail investors might be the lowest priority for many professionals on The Street.

Analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent. Over this time frame, actual earnings growth surpassed forecasts in only two instances, both during the earnings recovery following a recession. On average, analysts’ forecasts have been almost 100 percent too high. This is the reason we avoid using the consensus growth estimates from sources like finance.yahoo.com.

“Exceptions to the long pattern of excessively optimistic forecasts are rare… Only in years such as 2003 to 2006, when strong economic growth generated actual earnings that caught up with earlier predictions, do forecasts actually hit the mark.” When economic growth accelerates, the size of the forecast error declines; when economic growth slows, it increases.

Growth has been challenged and the trends have been impacted for a while now — so the Goldman Sachs miss should probably be placed in that context. Going forward, we’ll test the whole bell curve (not just the ends) with bigger samples and reconcile versus ACE.

For now, it appears that Elmo’s “D” grade for “Goldman Sachs 2015” was earned.