Enter a symbol:
For Toronto: TSX:TD
 



 
You are here :  Home > Articles > Page 4 > Caution! Analysts Revise Their Recommendations And Forecasts
 CAUTION! ANALYSTS REVISE THEIR RECOMMENDATIONS AND FORECASTS
 

   This is a translation of the former paper published by André Gosselin on the OrientationFinance.com web site on June 03 2004 (Read the original paper in French here).

 

   * Extract written by André Gosselin published in his book "Investir dans les titres de petites entreprises".

   The work of financial analysts can be described as such: They seek to forecast the results found in company quarterly and annual financial reports. Upon publication of these financial data, analysts react by either reiterating their forecasts and recommendations, or by revising them if the financial results deviate substantially from their predictions In this last case, they try to justify themselves and to give the reasons why the actual results of the company deviate so much from their forecasts. An aspect of the analyst job thus consists in stating in their reports justification arguments, a kind of subtle rhetoric, by which they explain their errors.

   Most of the analysts readjust their forecasts and their recommendations as soon as possible after the companies' profits have been published. These revision activities are obviously more significant when the financial results of the companies deviate from the forecasts (in particular when the actual profits are lower than the expectations) and when several analysts follow the same company. When the profits exceed the analyst's expectations, this one is reassured and will write a new report only if he is convinced that he must upgrade his forecasts for the next quarters. When, on the other hand, the profits are lower than his expectations, the analyst feels obliged to remake his duties and to justify himself, even if he is convinced that his forecasts will not change for the other quarters.

   In particular, the intense readjustment activity of the analysts' recommendations and profits forecasts is deeply related to what is called the surprise profits. It is enough to follow the analysts' profits revision activities and recommendations' updates to spot securities with returns higher than the average. Moreover, the bigger the difference between the initial forecast and the corrected one, the higher the stock price rise in reaction and the longer this reaction lasts (up to six months). Financial science has largely demonstrated this causal relation so I'm not insisting there too.

   The investor tends to believe, not without reason, that when the analyst renews his recommendations, he also readjusts his profits forecasts of the companies. Of course, a buy or sale recommendation can change for several reason, but, generally, if the analyst readjusts his recommendations, that is because he has adjusted his profits forecasts.

   Professors Jennifer Francis and Leonard Soffer (in 1997) showed that, for a given security, the changes in the analysts' recommendations have an effect on the stock prices which is partially independent of the changes in their profits forecasts. They noted, however, that the investors attach a greater importance to the profits revisions when they come with a recommendation to hold or to sell the stocks.

   Surprise profits and small capitalization securities: an excellent vein

   Claudia Mott is an authority in the institutional investors' circles specialized in the small capitalization securities. Prudential Securities first vice-president and director of the research centre on small capitalizations, Claudia Mott supports a mechanical and quantitative approach of the investment. One of the market anomalies she prefers is the surprise profits one. Research she conducts with her Prudential Securities team have convinced her that the strategy which consists in choosing securities according to the non expected profits (profits which exceed the analysts' expectations) is one of the best methods in the small capitalizations segment.

   We already know that the companies which publish profits higher than the analysts' expectations and professional investors tend to overperform in a substantial way during the few months which follow. This surprise effect, if we believe Graja and Ungar, would be amplified within the small capitalization securities. For instance, providing positive profits higher than the analysts' expectations generate on average, in the small capitalization category, a performance of the stock 13,7 % higher that the average for 3 months, against 5,7 % for the big capitalization securities.

   The first works about the unexpected profits of the companies and their effects on the security prices go back to the beginning of the 70s, in particular, thanks to the contribution of professors Latané, Jones and Rieke. They have discovered that, when companies declare profits unexpected by the analysts, higher than what they were waiting for, the price of their security enjoys a performance beyond the average. The researchers have also observed that if unexpected profits are announced for one quarter, it is likely that the publication of the next quarter results will also include profits unexpected by the analysts. This phenomenon is called "the cockroaches' theory". As the presence of a single cockroach is the clue that others are hidden, one quarter of surprise profits hardly comes alone. And this, no matter what the size of the companies is.

   Among all the factors included in the quantitative models tested by Claudia Mott, the "surprise profits" effect is the one whose performance is the most constant in the small capitalization market.

   On average, when small companies declare profits which exceed the analysts' expectations, the price of their stocks, for the next 12 months, overperform by 12,9 % the small capitalization security index Russell 2000.

   "The cockroaches' theory" can also be applied to the small capitalization security sector. Indeed, 34 % of the companies which reported unexpected positive profits during a first quarter repeat the surprise during the next quarter. On the other hand, 41 % of the companies which have declared profits lower than the expectations during a first quarter repeat this bad surprise during the next quarter. However, the bad surprise effect is not as catastrophic on the stock price, because on average these companies underperform the basic index by 3,5 % during the next year. Lastly, the industrial sectors where to find the most unexpected profits declarations are those of the health care, the financial services, the technology and the consumer products.

   André Gosselin

 
 
 
Copyright ©2004-2019 Agnosoft