The Hindu Business Line : Equity research: Should reports provide recommendations?

Equity analysts are in an unenviable position. When asset prices cantered up between 2005 and 2007, they initiated coverage on a large universe of companies. Several of these stocks are currently trading at half their estimated intrinsic value.

Even as analysts are considering revising the estimated values, investors are questioning the efficacy of these reports.

This article discusses the role of equity research and its use for traders and investors.

It argues that analysts would do well to acknowledge the presence of noise traders and the fact that asset prices wander away the estimated intrinsic value.

Acknowledging this fact and stating the same in the report would enable the analysts to add considerable value to the investment process.

“Generating” value

Research reports are primarily consumed by institutional investors and HNIs. These investors believe that their horizon is “long-term”.

Sure enough, analysts typically forecast cash flows for ten years to arrive at the present value.

The problem, however, arises when analysts “calibrate” the intrinsic value to the market. When the market is trending up, analysts use a lower cost of equity to “generate” a higher present value.

Likewise, analysts use a higher cost of equity to “generate” a lower present value when asset prices are trending down.

If analysts are capturing the “fundamentals” of a company, why are they swayed by the market conditions? The answer, perhaps, lies in the Catering Theory of Analysts Bias. This theory states that the analysts are heavily influenced by what investors believe.

One indicator is in the “boldness” of the research reports since 2005.

Analysts have tended to place price objectives that are far above the market price in line with the trending market. An example is a research report issued by a sell-side firm on TV18, where the analyst revised upwards the estimated value by 80 per cent!

Such “boldness” gives away to diffidence when asset prices tank.

Trials and tribulations

In a market that is trending up, the price objective is often reached in a short time. Take Bharti Airtel. A sell-side report placed a 12-month price objective of Rs 1,025 on the stock in its report issued in August 2007.

Two months later, the stock reached its price objective! It is highly likely that the analyst was tempted to use a lower cost of equity to generate a higher estimated value in the next report.

Another problem arises when asset prices tank so that the estimated value in the report seems too far away. Take Sadbhav Engineering. An Indian brokerage firm placed a price objective of Rs 1,100 this July. The stock has since declined from Rs 750 to Rs 525. Will this prompt the analyst to revise the DCF value?

It is intriguing that research reports have not been that forthcoming since the market crashed this January.

For if research reports are about fundamentals, more reports should be issued when asset prices are lower.

That they are not suggests that even the report-consuming investors are concerned more about the near-term price movements.

Research reports based on fundamental analysis cannot cater to this investor bias.

Recognising noises

One way to tidy this problem is to recognise that asset prices wander far away from the estimated value due to noise trading. This refers to information-less trading that simply pushes asset prices far from the fundamental values.

Prices can stay away from fundamentals for a long time — long enough for rational investors to wipe out their capital if they take exposure against the prevailing trend.

Analysts should, hence, not be sanctimonious about the estimated intrinsic value. Reports should simply be a tool that enables investors to discern if fundamentals justify current valuations and future upside.

Take Power Grid. A sell-side firm placed a price objective of Rs 90 on this stock last year when it was trading at Rs 130, arguing that the stock was expensive based on forward price-earnings and forward price-book multiples. The stock moved up 30 per cent before declining sharply. But what if noise traders had driven the price to more excesses?

Research reports should stop offering recommendations.

Instead, such reports should merely capture the estimated intrinsic value based on the cost of equity that is not “calibrated” to market conditions. This would provide an unbiased estimate of the “fundamental value” of the stock.

Better yet, analysts should specifically mention in the report that asset prices trading below or above the estimated value do not necessarily lead to a buy or a sell decision.

To facilitate the trading process, research reports should be supplemented with technical analysis that can provide trading strategies adjusted for noise-trading effects.

That way, analysts can rest easy, not dragged down by the short-term price volatility. Equity research would have then added considerable value to the investment process.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)