WHAT EVERY INVESTOR SHOULD
KNOW ABOUT STOCK ANALYSIS
Half textbook, half expose, a new book explains it all
Every three months, Wall Street throws an invitation-only dance called
earnings season. On one side of the ballroom are the chief financial officers
of companies that are about to report their earnings. On the other side are
the analysts, whose job it is to guess those earnings. The dance comes to an
end with the company usually announcing numbers that are amazingly close
to what most of the analysts guessed.
From the point of view of the individual investor, this world seems about as
real as Merlin's. Indeed, the predictive abilities of the analysts of Wall Street
appear to be nothing less than magical, and individual investors often see the
analysts as wizards, hunched over cauldrons of data, summoning a crystalline
vision of the future.
The truth is a little bit more complicated. Analysts usually get their earnings
predictions from hints dispensed by executives of the company being
"analyzed." An average CEO has a good idea of what the quarterly earnings
will be well before the end of the quarter and will pass that on -- one way or
another -- to the analysts that cover the company.
Of course, the system shouldn't work that way. The sad thing about how Wall
Street's analyst community operates is that it's possible to analyze a stock
and come up with an investing recommendation by rigorously examining
publicly available data, but most analysts don't. The brokerage houses that
employ them see analysts as salespeople who can bring investment banking
business to the firm, rather than as analysts.
UNLIKE BUFFETT. The best analysts still do the scut work. Take Warren
Buffett. Although he's famous as a money manager, his skill as a stock-picker
is based on his old-fashioned analytical expertise. You better believe he
knows how to take apart a balance sheet, an income statement, and a
cash-flow statement (the three primary financial statements every public
company is required to file with the SEC). Although most sell-side analysts
(those employed by brokerage houses) claim that they can do the same, you
can't tell it from their records. Analysts hardly ever put a sell recommendation
on a stock because if they did, their employer might lose other business from
that company.
Into this environment comes a new book, Security Analysis on Wall Street by
Jeffrey C. Hooke. It's an unusual cross between a textbook for
analysts-in-training and a tell-all expose of the analyst profession in its
current state. Although the marketing machine promoting the book has
attempted to cast it as the successor to Graham and Dodd's classic text
Security Analysis, that's something of a silly stretch. The basic disciplines in
that book (buy low and sell high) are true today, and will be forever. But this
book has something even better than Graham and Dodd: It gives the reader
an easy-to-understand glimpse into the process of stock analysis and doesn't
hold anything back about the shady side of the profession.
For instance, Hooke goes into great detail about the inherent
conflict-of-interest of sell-side analysts. "Brokerage firms are primarily in the
business of generating banking fees, commissions, and trading profits," he
writes. "Providing unbiased research to investors ranks low on their list." So
why pay any attention to sell-side analyst reports in the first place? Because
they still can provide important bits of information. You just have to know how
to interpret them through the fog of the multiple conflicts-of-interests involved
in the company-analyst relationship. And this book does a good job of
teaching the individual investor how to do that.
MISPLACED INFO. Hooke doesn't stop at revealing the underside of the
analyst community. The book also warns investors how companies often
massage financial statements to make them say what they want them to. For
instance, a debt-laden company might want to make its balance sheet look
less leveraged by placing the lease costs that it pays on office space under
the heading of rent. In fact, if the lease is noncancellable, then the proper
place for lease payments is under debt. While this might not seem like much,
it can make all the
difference when that company applies for credit from a bank. If the bank
uncovers the misplacement, which is legal but misleading, it might not issue
credit to the company, thereby harming its ability to function. In other words,
you don't want to own stock in a company that does that kind of thing.
One thing the book makes clear is that every analysis is only as good as the
data that's provided by the company. Analysts who cover companies such as
Livent and Cendant, both of which were recently forced to restate earnings
because of fraudulent data, have been attacked in the press for not
uncovering the fraud themselves. But that criticism is unfair. Analysts have to
assume that the numbers provided by the company are correct. If the
numbers are incorrect, then it's a fraud perpetrated by the company, not by
the analysts.
The book is divided into four sections. The first explains the investing
environment in which the analyst plays a leading role. The second describes
how an analyst prepares the research report. The third describes the process
of coming up with investing priorities. The fourth goes into detail about eight
different types of stocks (from highly speculative stocks to natural resources
stocks to emerging-market stocks).
While a particularly studious individual investor would probably benefit from
reading the book cover-to-cover, that's a job better left to an MBA student.
For most individual investors, Hooke's tome is more valuable as a reference
than as a textbook. The introduction and first section are required reading.
The last section, which lists different categories of stocks and how to analyze
them, could be an invaluable resource. For instance, if you've just been given
a tip on a gas stock but don't know what to look for when researching it,
Hooke will tell you how to determine a reserve production ratio or a lifting cost
and place them into the industry's context, and why that's important for this
type of stock.
The most important tool an individual investor can have is an ability to chip
through all the rocks to find a nugget of gold. This book is an invaluable,
although expensive, pickax.
Note: This story originally appeared on BW Online's Daily Briefing on Sept.
17, 1998.
By the way, this book is in stock at:
barnesandnoble.com |
