Why I Never Read Reports from Financial Analysts - Updated

I recently attended a very interesting micro cap investing conference in Toronto.  Approximately 35 companies made investor presentations.  I will write about a few in them in a subsequent post.

A very interesting part of the conference was meeting other investors and listening to their questions following each presentation with the purpose of studying their thought processes.

All of them were very well educated people and most had significant experience in the financial industry.  I was struck by a few things:

•  Their questions were predictable.
•  For the most part, they focussed on financial metrics and competition.  

With a few exceptions, they paid little attention to what I consider are the most important aspects of evaluating a potential investment:

• There was not one question about the quality of management.
• I was the only person who asked about staff retention, a key element to the success of small knowledge-intensive enterprises. 
• There were only two questions about the strategic positioning of a company - this despite a long runway that was provided by company executives who had sweated bullets about this key element of a business plan.
• There was hardly any attention paid  to marketing - either to the investment community or to consumers of a company's services/products.  To my mind, this is astonishing, especially when the company presenters had frequently mentioned this.  

I came to the conclusion that most analysts do not conduct their due diligence from the perspective of an owner/operator.  In part, this was due to the fact that most of them had never run a business .... or ... perhaps in their role as financiers or analysts, their perspective changed to the textbook MBA template.   

Further, the foundation of many questions was based on metrics which looked at investment risk.  This is a subtle point.  For example, some companies had made some major strategic adjustments in order to survive.  Not once did the concept of resilience arise.  To my mind, the capacity of a company to shift its focus is a very positive attribute - something to be treasured and which cannot be measured on a balance sheet. 

I was also struck by the narrowness of many "suits" in terms of their perspective.  They simply lacked the ability to think about how companies are perceived by other than the professional investment community.  

A case in point was Input Capital.  I discussed the company with an experienced professional investor.   He made two remarks:

• noted that the company had lost a major streaming contract that went south
• that why would he invest in such as company as he had great expertise in commodity trading - why engage the services of Input Capital?

I was too polite to take him to task at the table but here is my take:

• It is expected that young companies will encounter glitches along the early road, particularly those with pioneering business models.  I informed him gently that Input quickly moved to tighten its due diligence and to reduce the size of streaming contracts - also that it had negotiated many more contracts thereafter.  I was impressed by the ability of the company to learn and adjust its practices.
• As to the "why" of investing in a company, the man was blinded by his outlook.  He looked at the company from a strictly personal point of view and ignored the possibility that others might have a different outlook.  To my mind, the company provides a retail investor with diversification to agricultural commodities (in this case, rape seed) and also the potential for gain due to the profitability of the company.  He is entitled to his opinion as I am to mine ... and thank heaven for that. As my father-in-law used to opine:  "That's why they make Fords and Chevs."  

In my approach to assessing an early-stage company, I admit that I focus primarily on the "softer" side of things:

• quality/integrity of management
• ability to learn and adjust and resiliency
• strategic positioning 
• robustness of the business model
• customer benefit
• intellectual property management
• marketing

On the harder side, I look at:

• balance sheet
• burn rate
• access to funding (internal, external)
• market potential

I also look for catalysts with the potential to change a company's outlook for good or bad.  

In the end, it is people who determine the future of a business.  An idiot with money and good financial metrics is useless.  A genius without money usually finds ways to surmount issues, including things financial.  To my mind, the present state of the financials of a young business represents but a small aspect of a company's potential.

Most analysts appear to give short shrift to the human element and that's why I do not read their reports.  As to their projections of future earnings ... well ... the ancient Greeks probably had a better methodology by appealing to the Gods.  Besides, the cost of bringing a goat to the altar was probably much cheaper than the fees charged by today's temples of finance.  See Oracle of Delphi

OK.  This is has been a rather harsh indictment of template thinking but I advanced the argument this way in order to make a point about analysis by rote - the stuff which litters the field.

I do read several financial blogs.  The best of them advance a more informal style and reflect the individuality of their authors.  In reading them, I am more interested in the authors' thinking process - how they adapt their thinking to the needs of the moment.  The best of them have an ability to zero in on the most important considerations which contribute to the "investment worthiness" of an enterprise.  That is the real art of financial analysis.

One Last Observation

Do the analysts' recommendations make a difference?  The answer is "no".

For decades, researchers have reported that post-revision return drift, or PRD, moves in the direction of analysts’ recommendation revisions; this is to say, PRD is typically positive following upgrades and negative following downgrades. New evidence provided in this article shows the disappearance of significant average PRD that agrees with analysts’ revisions, in the 2003-2010 period. ...

The findings add to the empirical evidence about analysts’ information intermediary role in the securities market. They do not support the view that analysts’ reports consistently provide the typical investor with useful new information about long-run stock price behavior, which complements recent research suggesting that analysts’ reports generally provide little new information for investors in the short-run. They also suggest that it could be difficult for analysts to provide useful new information for ordinary investors in a low transaction cost environment. 

Read the full paper.  Can analysts predict stocks for the long run?