Basic Incompetence of the Analysts

The Basic Incompetence of Many of the Analysts Themselves

The overall performance of analysts in many respects reflects the limit of their abilities. Their record with regard to STP Corporation is certainly a good example.

In the early 1970s, racing car driver Andy Granatelli’s STP was the darling of the Wall Street fraternity. Report after report indicated why it was likely to enjoy a large, long-term growth rate. Analysts pointed to its consistent pattern of growth over ten years. On the argument that the future would be more of the same, and that STP could continue to create its destiny through its marvelously successful advertising campaign, the Wall Street fraternity gave STP an estimated 20 percent growth rate for earnings in future years. As STP”s stock price rose, analysts recommended the shares with greater and greater enthusiasm. Needless to say, but said nevertheless, STP management actively encouraged this enthusiasm.

Few analysts bothered to ask about the company’s major product. STP oil treatment, which apparently accounted for three-quarters of the firm’s revenues and earnings. What did the product really do? Could one really believe that STP helped cars start faster in winter and made engines run longer, quieter, and cooler in summer?

Admittedly, some analysts had a queasy feeling, but this was carefully reasoned away. For example, in the May 17, 1971, issue of the Wall Street Transcript, one analyst was quoted as saying: “The risk is that it is difficult to prove what exactly the product accomplished, and people fear that the FTC might attack the company on an efficacy basis. We feel there is a very low probability of that happening and in the meantime consumers think the product works and that’s the important thing. It is sort of a “cosmetic company” for the car. If ever there was a castle in the air, STP certainly qualified.

David A. Balfour Park in Rosedale. Photo by Elena

While the above analyst was being quoted, Consumer Reports was completing its report on STP. This was published in July 1971 and stated that STP was a worthless oil thickener, not a panacea that would make ailing engines healthy again. Indeed, the consumer magazine reported that “STP can change the viscosity of a new car’s oil to a considerably thicker grade that certain auto manufacturers recommend.” The magazine went on to say that the major auto manufacturers positively discouraged the practice of using such additives, and suggested that STP might modify the properties of a car’s engine oil so much that the new-car warranty terms might be affected.

To be perfectly blunt, many security analysts are not particularly perceptive, critical or competent. I learned this early in the game as a young Wall Street trainee.

The stock fell abruptly and the company’s consistent record of past earnings growth came to an untimely end. As one analyst confided after the debacle, “I guess we just didn’t ask the right questions.”

In attempting to learn the techniques of the pros, I tried to duplicate some analytic work done by a metal specialist named Louie. Louis had figured that for each 1 cent increase in the price of copper, the earnings for a particular copper producer would increase by $1 per share. Since he expected a 5 cents increase in the price of copper, he reasoned that this particular stock was “an unusually attractive purchase candidate.”

In redoing the calculation, I found that Louis had misplaced a decimal point. A penny increase in the price of copper would increase earnings by 10 cents, not by $1. When I pointed this out to Louie (feeling sure he would want to put out a correction immediately) he simply shrugged his shoulders and declared, “Well, the recommendation sounds more convincing if we leave the report as is.” Attention to detail was clearly not the forte of this particular analyst. From then on I referred to him as Sloppy Louie (not to denigrate the excellent fish restaurant of the same name near the New York financial district).

To balance this inattention to detail and careful work, we have those who glory in it. Take Railroad Roger, for example. Roger will accurately recount every conceivable statistic on track miles and freight carloadings for hours on end. But Roger does not have the faintest clue what the rails will earn next year, or which should be favored for purchase. Oil analyst Doyle performs in a similar manner. His knowledge concerning refinery capacity is encyclopedic, but he lacks the critical acumen to translate this into judgments useful for investment decision-making.

Many analysts, however, emulate Louie. Generally too lazy to make their own earnings projections, they prefer to copy the forecasts of other analysts or to swallow the ones released by corporate managements without even chewing. They it’s very easy to know whom to blame if something goes wrong. “That treasurer gave me the wrong dope.” And it’s much easier to be wrong when your professional colleagues all agreed with you. As Keynes put it, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”

Corporate management goes ot of its way to easy the forecasting task of the analyst. Let me give you a personal example: A two-day field trip was arranged by a major corporation to brief a whole set of Wall Street security analysts on its operations and future programs.

We were picked up in the morning by the company’s private plane for visits and briefings at three of the company’s plants. In the evening we were given first-class accommodations and royally wined and dined. After two more plant visits the next day, we had a briefing, replete with slide show, indicating a “most conservative five-year forecast” of robustly growing earnings.

At each stop we were showered with gifts – and not only the usual souvenir mock-ups of the company’s major products. We also received a variety of desk accessories for the office, a pen and pencil set, cigarette lighter, tie bar, cuff links, and a tasteful piece of jewelry to “take home to the wife or mistress, as the case may be.” Throughout each day liquor and wine flowed in abundance. As one bleary-eyed analyst confided at the end of the trip, “It’s very hard not to have a warm feeling for this company.”

I do not mean to imply that most Wall Street analysts typically receive payola for touting particular stocks. Indeed, from my own experience, I would judge that the standards of ethics in Wall Street are very high. Sure, there are crooks, but I would guess far fewer than in other professions, despite the celebrated insider trading cases of the late 1980s.

I do imply that the average analyst is just that – a well-paid and usually highly intelligent person who has an extraordinary difficult job and does it in a rather mediocre fashion. Analysts are often misguided, sometimes sloppy, perhaps self-important, and at times susceptible to the same pressures as other people. In short, they are really very human beings.

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc