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Traders work on the floor of the New York Stock Exchange on Nov. 25, 2013. (BRENDAN MCDERMID/REUTERS)
Traders work on the floor of the New York Stock Exchange on Nov. 25, 2013. (BRENDAN MCDERMID/REUTERS)

A literary critic’s guide to deciphering analyst reports Add to ...

If you cast your mind back to English class, you’ll recall Percy Bysshe Shelley, the early 19th-century bad boy who boasted that poets are the unacknowledged legislators of the world. He was, of course, utterly wrong. As we now know, the real power brokers are Wall Street analysts.

Think about it: Simply by writing a few sentences, a prominent analyst can send a stock careening up or down. That’s an awesome power to possess.

Shelley obviously never worked in finance. But let’s give him his due: He was one of the first to draw attention to how mere words can shape the world. In fact, if you read enough analysts’ reports, you may be struck by the ways in which poets and analysts work in similar ways. Both tend to hide their meanings; both dwell in the realm of the, um, fanciful.

So let me offer a literary critic’s guide to the investment industry—or at least three principles you should keep in mind the next time you flip through an analyst’s report.

It’s all about subtext

“Tell all the truth, but tell it slant,” the poet Emily Dickinson advised. Analysts have taken her advice and rarely issue an outright “sell” recommendation. A “hold” label really means “be careful,” while a “buy” recommendation can signify anything from “this is mildly interesting” to “mortgage the house and load up.”

How do you translate this mishmash? Pay the most attention to negative recommendations. An analyst who issues a damning report on a company can expect blowback from its management, so a “sell” recommendation nearly always reflects serious conviction on the analyst’s part. You can’t say the same about more upbeat reports, which sometimes seem to be run off, in bulk, by analysts who want to maintain good relations (and access to) the companies they’re covering.

Numbers are fiction

Analysts say they base their calls on quantitative models that project future earnings and dividends and then distill those returns into a current discounted value. It sounds scientific. The problem is that nudging the assumptions by a millimetre can swing the figures wildly up or down.

The fragility of the models means target prices for stocks are in a constant flux. Ezra Pound, the American poet, exhorted writers to “make it new.” Analysts do just that, constantly revising their projections. They start out fiercely optimistic about what the next year will bring, then “walk down” those figures as reality intrudes. Companies wind up beating expectations—but those expectations are often below what analysts expected a year before.

The lesson for investors: If you’re looking at target prices, or earnings forecasts, for any period more than six months ahead, you’re essentially reading fiction.

Beautiful minds

Analysts are smart—equipped with CFAs and MBAs. But does that make them great stock pickers? Remember Allen Ginsberg’s famous opening line to Howl: “I saw the best minds of my generation destroyed by madness.”

In 1933, economist Alfred Cowles published a landmark paper demonstrating that analysts’ picks failed to keep up with the market. In the decades since, researchers have failed to prove that analysts have any ability to foresee stock prices, especially when you take into account real-world factors such as trading commissions and taxes.

All this suggests the best way to read analysts’ reports is for insight, as a check on your own preconceptions, and for general interest, but not as a practical guide to managing your investment portfolio. In other words, think of analysts as an exotic variety of poets and you’ll do just fine.

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Follow on Twitter: @IanMcGugan

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