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Gloomy Outlook Tests Analysts’ Confidence

Simon Mundy, Kate Burgess HKSCKPVIamp; Alison Smith, Financial Times

It is hard to envisage a less propitious climate for equity analysis than a gloomy outlook for advanced economies combined with sustained and severe market volatility.

The S&P 500 and the FTSE 100 have each lost almost a fifth of their value compared with their peaks earlier this year, while the main volatility index, Vix, has been above 30 since the start of August, making this the longest continuous period it has stayed above that threshold for more than two years.

“The world’s not very easy to forecast at the moment. Analysts are not very good at turning points,” says one fund manager, recalling a note on the retail sector that ranked companies by their exposure to China, whereas a month earlier the same note would have ranked them in reverse order.

“It is difficult to make any kind of forecasts with any great degree of confidence,” says Keith Baird, who covers UK financial stocks for Oriel Securities. “In my area it’s got to the point where it’s very hard to say anything... ?but you’ve got to take a view, that’s what you’re paid for.”

So as earnings forecasts look vulnerable to further darkening of the macroeconomic picture and market fluctuations make target prices look implausible, equity analysts must adapt to conditions when analyzing individual stocks using traditional corporate measures does not necessarily carry the same weight with clients as it did in the past.

One approach is to focus on different aspects of corporate performance. “We’ve been asking what would happen if access to the capital markets dried up today, tomorrow or in six months’ time: would this company be able to fund itself?” says Steve Biggar, global head of equity research at Standard & Poor’s.

“In periods of growth, we use [sell-side] analysts to understand where that growth is coming from. But now the emphasis is away from earnings growth towards balance sheet strength and sustainability,” says Stan Pearson, European fund manager at Standard Life Investments.

The most famous recent occasion when normal analytical tools seemed to lose their usefulness was the 1990s dotcom bubble. “That was when normal corporate metrics didn’t apply,” says Mark Mahaney, internet analyst at Citigroup, writes Alison Smith.

As analysts look at the current wave of tech initial public offerings — such as LinkedIn and Pandora which are already trading and others such as Groupon and Zynga which have been held back because of market turbulence – they are conscious of the lessons learnt last time around.

“I guess the single biggest lesson was the level of risk involved in some of these stocks, and how quickly they could fall in and out of favor,” Mr. Mahaney says. “When I think about the current wave of IPOs, the lesson is that the market capitalization concentrates on just a few names: you’re likely only going to have a few significant winners out of many IPOs.”

He believes that where the corporate assessments went wrong last time was not in assessing market opportunity or even the attractiveness of the business models. Analysts often thought sustainable competitive advantages would be greater than they turned out to be.

To Scott Kessler, head of the tech group at Standard & Poor’s, the key lesson from the dotcom bubble was overreliance on relative analysis. On that basis, across three companies analysts might “recommend one, because even though the... ?valuation seemed quite high, it seemed OK because it was lower than those of the other two. But when they all crashed, there was nowhere to hide”.

Though relative analysis still plays a part, he says he looks at other factors, such as sum-of-the-parts analysis and discounted cash flow.

Analysts may also explicitly admit both what they are assuming and what they cannot know. Robin Bienenstock, a telecoms analyst at Sanford C Bernstein, says analysts have to be clear about their broader assumptions “otherwise your stock calls don’t really mean anything.

“You can’t put a ‘buy’ on Portugal Telecom , and then not mention the fact that you think [Portugal] will stay in the euro.”

Richard Repetto, an analyst at Sandler O’Neill, says good research shows how a company’s performance might vary according, say, to different levels of GDP growth. “If you provide sensitivity, you’ve helped someone understand what the impacts are while acknowledging any specific forecast is very difficult and highly uncertain.”

For others, the key is about providing analysis that is less dependent on specific predictions. “Today we get asked about global themes or thematic plays as people look for guidance in how to assess what it happening,” says Mr. Biggar, citing interest in China and in European sovereign debt.

Lee Simpson, a technology analyst at Jeffries, says analysts are rewarded for a broad approach rather than going through the figures in the balance sheet. “That carries little or no weight in my sector now. It’s a lot more about strategic analysis.” Fortunately for analysts, a preference for strategy over number-crunching often plays into the continuing evolution of their relationship with the institutions who are their clients.

Investors’ attitudes to analysts at brokers and banks have frequently been tinged by cynicism over potential conflicts of interest, and the suspicion — at its height in the 1990s bull run and the dotcom bubble — that overly optimistic research notes may have been issued to win investment banking business.

Now institutions have more financial analysis in-house, they look to sell-side analysts for a wider range of insights. “Some have deep contacts and knowledge of a company... some understand an industry without being able to see how that knowledge translates into the share price,” Mr. Pearson says.

They are also finding that even when market fluctuations make it difficult to discern what is happening, investors still value their specialist knowledge.

“One or two clients have been saying that in times of volatility when analysts find it quite hard to understand what’s going on, there’s been extended periods of radio silence,” says Andy Smith, consumer industries analyst at MF Global. “So we’re trying to pick up the phone more often and talk to our clients, and keep them in the flow.”

Advocating patience, Robert Munsters, chief executive of Dutch fund managers Robeco, says: “When markets are in such disarray we can drive ourselves crazy going round in circles trying to work out what to do. If you look at how much pension funds have ‘lost’ in the past two months from the global falls in financial markets, it dwarfs the few hundred billion that banks and sovereigns have lost in the euro crisis”.

Such stoicism looks set to be tested in the months ahead.