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You are here: Home / General / The Forest and the Trees

March 8, 2011 by John Duncan

The Forest and the Trees

Many investors cherish the notion that if they only had instant access to the information sources of market professionals—the stock research and broker calls and economic forecasts—their wealth-building dreams would be much further advanced. So, what if you had acted on those big professional calls in the past year?

Financial information group Bloomberg1 recently carried out an analysis of broker recommendations for stocks in the US equity benchmark, the S&P 500 index. It found that the companies that analysts recommended most highly rose by 73 per cent on average in the period from the trough of the market in March 2009 until early 2011.

That sounds pretty good until you realise that the index itself rose by 88 per cent in the same period. Now, compare the performances of the most loved stocks against those with the fewest buy recommendations in the Bloomberg survey. This latter group rose by 165 per cent on average during that period, or more than twice as much as the “top” stocks.

Why analysts get it so wrong can be easily explained: News. Everyone has a theory or two about what will move the market in the coming year, but this always depends on at least a couple of variables. First, you have to know what’s going to happen. Second, you have to know how the market will react. And even if you have the perfect crystal ball, there’s no guarantee that the market will respond the way you think it will.

A few years back in Australia, an analyst covering the tourism sector was asked about the calls he made in the year just ended. He said he didn’t do too badly overall, but there were a couple of exceptions. Firstly, his buy recommendation on a resort in Australia’s snowfields came awry when it failed to snow that season. Secondly, his enthusiasm for a Thai resort proved wrong when that country experienced a military coup. “But that’s OK,” he replied. “I couldn’t have foreseen those events.”

This is the problem with the future. No matter how much analysis you do, it doesn’t often work out like you think it will. For instance, analysts in the Bloomberg survey made a big call in favour of healthcare stocks based on the expectation that the Obama administration’s healthcare reforms would not pass into legislation. As it turned out, the legislation did pass and healthcare was the worst performing of the 10 economic sectors in the S&P 500 last year.

Conversely, a year ago, there was great scepticism about the durability of the US economic recovery. The Wall Street Journal2 in early 2010 ran a piece entitled ‘Four Reasons to Remain Cautious’ and cited as one of them the risk of a “double-dip” recession as fiscal and monetary stimulus was unwound. As it turned out, the best performing sector on the US share market in 2010 was consumer discretionary, a sector tied to the strength of domestic demand.

In Australia at the start of 2010, The Australian Financial Review3 ran a piece called ‘Twenty Stocks to Fire Your Portfolio for 2010’. The article was based on stock picks from five “specialist” fund managers. In the ensuing year, of the 20 stocks chosen, seven outperformed the S&P/ASX 300 accumulation index, 11 underperformed and two were either acquired or restructured.

Indeed, some of the recommended stocks did not just undershoot the index, they crashed and burned. Among these were information technology provider iSoft Group, whose shares slumped 90 per cent last year against a 1.9 per cent gain in the broad market. Maybe these weren’t 20 stocks to fire your portfolio, so much as 20 stocks to fire your portfolio manager?

The question that arises from this is if that the crème de la crème of the stock pickers—the professionals paid to analyse companies in mind-numbing detail—can get it so very badly wrong, what does that say about the chances of anyone being able to outperform the market based on individual stock research?

It seems that sometimes, the closer you get to the trees, the less you see the forest.

1. ‘Equity Analysts Prove Hazardous to Returns as Contrarian Stocks Rise 165%’, Matt Walcoff and Lynn Thomasson, Bloomberg, Jan 10, 2011

2. ‘Four Reasons to Remain Cautious’, Simon Nixon, The Wall Street Journal, Jan 2, 2010

3. ‘Twenty Stocks to Fire Your Portfolio for 2010’, Justin Bailey, Australian Financial Review, Jan 22, 2010

The above article supplied by Jim Parker, Vice President, DFA Australia Limited

Filed Under: General, Investment

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