Tuesday, August 30, 2005

They Get Paid For This, Part I

Teradyne upgraded to Neutral at BofA; tgt raised to $15.16 (16.62)

Thus reads a headline coming across my “Briefing.com” this morning.

“Briefing.com” is an excellent, subscription-based online service providing news behind stock movements, and during the pre-market hours it is chock-full of these types of upgrades and downgrades from Wall Street’s Finest.

What that headline means is this: the semiconductor equipment analyst at Bank of America has upgraded his rating on Teradyne, a solid, old-line company specializing in high-end test equipment, probably from “Sell” or “Underweight,” to “Neutral.”

Furthermore, the analyst has raised his target on the stock price to $15.16 a share, compared with last night’s closing price of $16.62.

For those of you rubbing your eyes at this, let me assure you of two things:

1. The “target price” is precisely $15.16. Not $15.15 or $15.14. It’s $15.16.

2. The “target price” on the stock is in fact 10% below last night’s closing price, and yet the stock is rated “Neutral.”

Now let me assure you that nobody I know pays any attention to either the price target or the “Neutral” rating. And, yet, they exist. So how could a Wall Street analyst come up with a “$15.16” price target, anyway?

Well, first the analyst finds some artificial multiple, such as the S&P price-to-earnings ratio or the average semiconductor price-to-book ratio or a peak-cycle-price-to-sales ratio.

Then his assistant plugs a bunch of numbers into their Teradyne model, runs them out five years, and starts multiplying earnings or book values or peak sales ratios times the various outcomes, and blends these into a meaningless “price target.”

As for why the analyst is “Neutral” towards a stock he expects will decline 10%, a quick look at the Teradyne chart reveals the stock is up about 50% from its May lows, and the analyst is probably getting tired of having a “Sell” or “Underweight” rating on a stock that keeps going up.

Merely by going to “Neutral” the analyst has reduced the number of hostile, “why are you so negative?” calls from any number of influential Teradyne shareholders—not only to himself and his assistant, but to his sales people, traders and investment bankers.

Plus, it is almost September, and in just a couple of weeks Bank of America will have its growth conference, and it will be much more comfortable for the analyst to introduce the company’s speakers at the conference if he is able to say “Teradyne is a Neutral-rated stock” as opposed to “Teradyne is a Sell-rated stock” in front of 500 clients who own Teradyne.

Don’t get me wrong: I am not being harsh or critical of the Bank of America analyst, whoever he is. Being an “analyst” on the sell-side is more of a marketing gig than a stock-picking gig, and has been since I was there in 1980. What I described here is simply how it really works, when you cut through all the spreadsheets and disclaimers.

But tomorrow we will look at a more egregious type of behavior from Wall Street’s Finest—the kind that results in a well-paid analyst being off by almost 100% on his “free cash flow” analysis of a money-losing company that has experienced a reduction in its cash balance, net of debt, from $170 million to almost zero in the space of nine months.

Analysts really do get paid for this kind of thing.

Jeff Matthews
I Am Not Making This Up

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.


Sam S. Park said...

Well said Jeff. You have opened the eyes of many of your readers that may place these sell-side analysts on a pedestal. I would love receiving their paychecks, and I have in the past wondered how these crystal ball target figures were derived. I was disappointed to find out that many high school students taking algebra could find this magic number.

However, there are plenty of analysts out there that put much effort to get the numbers right. Some take the time to really understand the business. Such analysts have a firm grasp of realistic forecasts and understand which variables really matter and have economic value. This part of the process remains vital before the algebra steps are applied. On the other hand, you have people like the infamous Henry Blodget who seemed to look for the variables that would give the highest target number possible. Man, talk about forcing the number.

Sam S. Park said...

Oh, I forgot to mention how relatively easy multiple regression modeling has become. You simple need to know how to use these statistics packages and test the independent variables for their significance. You just need to determine which variables to use and what statistical problems occur from the results.

rajesh said...

i think the job of an analyst is an impossible one. it is impossible to make predictions about the future because there is only onething certain about the future and that is that its uncertain.
giving price targets is just part of the job and there is nothing difficult about it because it all comes down to using some version of the dividend discount model. literally the first few chapters of a corporate finance book will show you how.
the earning estimates are given by the company themselves so its not like analysts spend days prediction future estimates. all you then have to do is look at the industry multiple average or historical p/e ratio for the company and you get a price target. no rocket science needed here. actuallu, have you ver noticed how most companies are able to beat the analysts earnings estimates? that's because they tell the analysts what they expect to earn and make sure they beat that. because they know that more times then not that will take the price higher.
the reason they employ analysts is that its an integral part of the product that brokerages offer. ask any institutional investor what they hink of sell side research and they wil say its crap. yet, if you are a broker and do not offer research they don't take you serious.
i think the reason they exist is that inherently when you buy a stock you make an inference about the future which is by definition uncertain. when you have something to say about the future, for some strange reason people will always listen. wether you are just an amateur or topnotch investor working for fidelity.
remember the old wild west where you had these salesmen selling "the elixir of life" promising the eternal life. people were buying it.
its part of the whole package of selling a stock that's why we have analysts.

actually, the idea of using analysts for selling securities stems from the mid 80's when salomon brothers used analyst to predict future prepayment rates when selling mortgage backed securities.

Paul said...

Jeff, as a buy-side analyst, I see this type of thing quite often. I agree with the point you are making.

In our shop we do not rely on sell-side analysts' recommendations. The value I see them providing is in information about a company or an industry and not whether a stock is a buy/sell/hold or some artificial price target.

Keep up the good work.

mamis said...

Aside to your post: I was a client of Mark Fitzgerald, the BofA analyst, for several years and he is a smart guy, one of the best in that sector. Unlike the others, he has an engineering background and actually understands what his companies's products do.

Not that this negates Jeff's main point; I just wanted to speak up for a guy who generally does a lot of good work.

stealthelephant said...

Sell side analysis provides a useful informational function. Few buy side firms have the capital or the manpower to replicate the research on the sell side. I think much of the research that the sell side performs is better than average. Nevertheless, if you're using written sell side research to govern your buying and selling decisions, I guess you will be standing in line waiting for those Spitzer shakedown checks. Who cares what their targets are? Who cares what the rating is? Please. This is war has been fought already. Find something else to complain about.

Sam S. Park said...

Paul and Mamis make a valid point in that these sell-side research has most of the value in the actual written research and information section... Too bad most people don't READ the best parts and put too much focus on the headline price targets and recommendations.

Aaron Koral said...

Analyst, schanalyst - just let me buy some index funds with low expense ratios and good tax efficiency, and who would need sell-side analysts then? Just my two cents...I would love to know, however, what company is off in its ccash balnce in such a short period of time! Keep up the great work...

stealthelephant said...

I half agree with Mr. Park that "most of the value is in the actual written work" and not in the headlines. But if any of you guys TALK to the analysts or bother to develop a relationship with these incredibly stupid people, you might discover what they really think sans the politics of ratings, written research, and estimates. I have found that what an analyst writes and what an analyst says to be qualitatively different things. If there is a dichotomy, that information can be profitable. C'mon guys, you should know this stuff.

Sam S. Park said...

Stealth makes a good point too. It's probably wise to actually speak with these analysts. And that politics will influence what is written. I guess this is something that will hover over our heads. I wouldn't go as far as to call these analysts "stupid," and we could pick up some pieces from their work. Then you can put various research together to make final decisions.

stealthelephant said...

In case my comment was misinterpreted: I don't believe sell side folks are stupid. I'm not sell side myself but I'm a proud apologist.

Sam S. Park said...

Here is an interesting article related to what we’ve been discussing here. Many of you probably realize this already, but click on the following link onBlogs vs. I-banking Analysts.

DaleW said...

In case my comment was misinterpreted: I don't believe sell side folks are stupid. I'm not sell side myself but I'm a proud apologist.

Agreed. Sure, the price targets and ratings are childish, but these are not stupid people. Like any tool, you need to know how to use it. A chainsaw can help you cut down a tree in 2% of the time it would take to do it with an axe and it can also cut off your arm. It all depends on how you use it. There are tons of smart people on the sell side who are forced into bad decisions by bad management, bad regulators, and bad clients!

RichL said...

Over the years, I've come to understand that the quality of all personal service work is based on the person doing the job, not the job category.

My first experience with Wall St. analysts was in the 1970's, when in doing work on a merger I found that the work of an II top-rated analyst on Gould was essentially a verbatim retelling of what the Investor Relations guy was saying. Other analysts I've encountered did original work and were excellent.

The inherent problem of the job on the sell side is that the imperative is to generate business. There isn't a perfect correlation between good stock picks and revenue generation. Personalities and salesmanship also matter. As with medical doctors, knowing who to listen to takes a network of friends who know who is good, and doing some work yourself to establish a base of knowledge to understand what you are hearing.