Tuesday, September 11, 2012

Quick Comment on Fundamental Analysis

So the conversation I overheard this weekend that I mentioned in the previous post reminded me of something.  Back when I used to talk a lot more to 'trader' types many of them used technical analysis, macro-forecasting, astrology and all sorts of other things because they claimed that fundamental analysis of stocks just doesn't work.

Part of it is that they are believers in the efficient market theory (never mind the irony that they think markets are efficient but they believe you can make money buying and selling stocks based on moving average cross-overs or some other such thing...).

As evidence that fundamental analysis doesn't work, they point to:

Wall Street Analysts are Always Wrong
Yes, analysts in aggregate are no better than random when it comes to forecasting EPS.   But there is a problem with this.  It's true that analysts spend all of their time analyzing the companies they follow so they should be able to be 'right' in their analysis.  But they often are not.  Their buy/sell recommendations are awful too, according to many studies.

But there are a few problems with concluding that fundamental analysis doesn't work based on that.  Here are some off the top of my head:
  •   Wall Street analysts always have to have an opinion.  If you cover an industry, you have to have an opinion.  You can't say, "I have no idea what this company will earn this year; it all depends on factors I can't predict".  This is just not acceptable on Wall Street.  Guys like Buffett and Klarman can be right often because they don't have to have an opinion on all 500 S&P stocks every single day of the year, every year.  Most of the time, they look at something and go, "I don't know".  And then only act on something they have conviction on.  This is very different from Wall Street analysts and even strategists that always have to have an opinion no matter what.  No wonder the results are random.   (Using Buffett's batting analogy, analysts and strategists have to swing on every pitch!  No wonder they strike out so often!!).  If Buffett had to fill out a form and say buy or sell for each of the S&P 500 companies, I bet he would be no better than Wall Street.
  • Wall Street Analysts Aren't Unbiased.  Wall Street exists to facilitate financing of businesses so they are long/buy biased.  Of course they are.  People complain that Wall Street issues 99% buy recommendations or whatever.   Part of that is because they want business and they just won't bother covering bad, trashy companies.  Why bother?  You can't have clients buy it, and you wouldn't want investment banking business with them.  How about investment banking clients?  Well, we all know the street is very unwilling to issue a "sell" recommendation. On the street, we know that if you are bearish and you are wrong, you will be fired quickly but if you are bullish and wrong, the guillotine doesn't fall as fast.
  • Wall Street Analysts Have to Focus on Short Term Results.  Contrary to popular belief, Wall Street is forced to accommodate client needs, and that is often short term profit estimating.  Clients demand accurate EPS estimates on a quarterly basis, even if it is actually impossible to provide.  So a lot of the resources are used up in that, and analysts are evaluated by it.  I don't think Buffett would be able to come up with more accurate EPS figures for his large holdings than any other analyst.  But that's not what Buffett's strength is, and that is not what matters.  But that's what the Street focuses on due to the structure of the industry.  Analysts are also evaluated on the performance of their buy and sell recommendations over short time periods.  Even Buffett can't do that well.

There's a bunch of other reasons why analysts are so often wrong (and some better than the above), but these are just some off the top of my head.   The point is, I don't think analysts' accuracy has anything to do with whether fundamental analysis works or not.  I tend to think it's an indication of how the industry works and nothing to do with the relevance or value of fundamental analysis.

Most Mutual Funds Underperform the Index
The other argument you always hear is that most mutual funds can't even outperform the S&P 500 index.  Every mutual fund manager seems to have a copy of Securities Analysis in their bookshelf,  and yet those very same managers underperform their index, year after year.

So therefore, fundamental analysis simply doesn't work.  There's too much evidence to show that it doesn't.  The number of mutual funds is high enough for it to be statistically significant.

But I have a different take on this.  Here are some quick points off the top of my head.  I'm sure I am missing better arguments, but here goes:

  • The industry in aggregate cannot possibly outperform.  Some will outperform and others will underperform.  In aggregate they will underperform by the amount of fees and expenses charged.
  • The industry is not incented to outperform.   This may sound strange as I think most mutual fund company CEOs want their funds to outperform.  I don't doubt that individual fund managers really want to outperform too.  But the industry is structured as an asset accumulation business.  Funds are incented to avoid large mistakes.  That's why there are so many closet indexers.  They don't want to stray too far from the index because if they underperform by a wide margin, they fear losing their jobs (or fear fund outflows).  This is why funds seem to be overdiversified, even when the fund is not so big.
  • Many funds are just too big to perform.  Many funds are just so huge now that they really can't veer too far from the index.  I would bet that even Berkshire Hathaway's equity portfolio has increased correlation to the S&P 500 index over the years as their holdings become much larger cap.  Fidelity Magellan is a great example.  What can you do with so much AUM?  Your universe of stocks to choose from is tiny.

When you really sit down to think about how the industry works, it is not really designed to perform well.  It is designed to retain and grow assets under management.  It's much more profitable to run a $100 billion mutual fund that lags that market (but keeps accumulating assets due to intensive marketing) than to run a $2 billion fund that outperforms the S&P 500 index.    So just as Buffett is stuck managing a huge portfolio for so-so returns when we know he can put up spectacular returns with $100 million, mutual fund firms tend to take their better managers and have them run the bigger funds (and give the smaller funds to young, next generation managers).

But the folks that can avoid these 'traps' tend to do well over time.  The superinvestors are proof that fundamental analysis matters.  Of course, Buffett is also proof of that.

There is a lot of data that supports the effectiveness of sound, fundamental analysis.  This is the village of Graham and Doddsville.

Technical Analysis
When I first started in the business,  I was huge into technical analysis.   It was very appealing to me as I didn't have to bother too much with research; reading reports, doing spreadsheets etc.  All I needed were some charts, a ruler and a pencil.  Or a computer for moving averages and other things like that. (Plus, technical analysis books were a lot thinner than Securities Analysis!).  There really is nothing more thrilling than drawing a trendline, watching a stock break below it and watch it continue to fall.

There are some people who have done well with charts; we know that even people like George Soros and Stanley Druckenmiller look at charts (even though I don't think it's their primary tool in most of their trades).

But at the end of the day, there really was no village of Edwards and McGee-ville (Technical Analysis of Stock Trends by these authors is considered the bible of technical analysis).  Yes there are some here and there that have made money from technical analysis.

But from my experience, it seems like most of the people who made money in this field made their money publishing newsletters and books.  

Are Wall Streeters Irrational?
Which leads to the next question; are Wall Streeters really all that irrational?  (OK, maybe this is an unrelated tangent).  They blow up with subprime.  They blow up their mortgage book.  Mutual funds constantly underperform the index and do irrational, stupid things like buy Yahoo stock at $250.

Is all of this stuff irrational? There have been books published that love to talk about how stupid and irrational Wall Street is.  I tend to agree at the big picture level.  But is it really so at the micro, individual level?

I don't think so.

When a mutual fund manager buys Yahoo even though he knows it is overvalued, is he acting rationally or irrationally?  He may be totally rational:  He wants to keep his job.  The odds are higher for him to be fired for not owning Yahoo than for buying Yahoo and losing money with everybody else.

Doing something because others are doing it is irrational at one level.  But doing it to keep a job is rational at another.

How about those 'dumb' Wall Street traders that always blow up?  Are they rational or irrational?

I remember a fixed income desk blowing up because they increased their balance sheet proportionately to the decrease in interest rate spreads.  I asked someone what the spread on their business was when they started.  They said 1000 bps (10%).  And then I asked what it was now.  They said 140 bps.

So over the years, to grow earnings (which the desk promised they would do to senior management), they had to increase their balance sheet to make more and more money as the risk increased (proportionately to the decrease in spread).

So they had the maximum balance sheet at the moment of highest risk, highest price and lowest spread.  And a minor speed bump in their business blew them out.

This merits the question; were these people irrational?  The casual observer would think so.  But more thought would make it clear that these people acted perfectly rationally. 

If the market didn't turn around, they would have gone home with huge bonuses.  If the market turned sour and they blew up, they would simply walk away (which is what happened).  In other words, they had a bonus pool every year so the only thing at risk for the desk was the bonus for that single year.  

Back then there were no clawbacks.  Of course employees (that are not shareholders or partners) are going to bet the ranch.  That is the totally rational thing to do at the individual level.

By the way, this is not an argument for banning risky behavior or increasing regulations.  This is about wrong incentives.  In the above case, I would blame senior management; not regulation or even the desk that blew up.

Buffett believes that regulations can't fix stuff like this; you have to give the right incentives for people.  Munger is huge on the incentive question too.  He thinks much of the wrong on the Street is not a regulation issue, but an incentive issue.  Buffett says that if CEO's and their wives had to go broke if their firm failed, they would act differently.  Same with traders; if they had clawbacks for previous year bonuses, this sort of betting the ranch bigger and bigger every year wouldn't happen (because they would have more to lose). 

So anyway, I meandered again...  Oh well.  It's my blog so I get to do what I want!


  1. Jebus. Even your "meandering" posts are good.

    Great thoughts all around; I totally enjoyed it.

  2. You answered my question about why large asset gatherers don't focus on outperforming the index. Overall great post even you think it wasn't great.

    1. Thanks for the nice comment (Cogitator too).

      Yeah, they are trying to optimize dollar profits, not percentage returns. I forgot to mention it, but the fact that they keep offering new fund after new fund (international this, international that, global value, global growth, global income and growth, global mid cap, global midcap value, global midcap value and growth, global small cap income, global balanced, global unbalanced etc...) is indicative of asset gathering behavior, not investment performance optimizing.

      It's counterintuitive; you would think that good performance leads to more assets, but that's often not the case... It's more profitable to just offer what the people want (offering an internet fund during the bubble, offering sector funds, theme funds, market neutral funds, hard asset funds etc...)

      No wonder they don't outperform; they don't have to.

  3. I am a former buy-sider fundamental analyst from a hedge fund and have a trading past (and present) but now sit on a floor of sell-side "equity" analysts. I would argue that these "equity" analysts are much more like business analysts and not "equity trading analysts". After watching analysts' equity calls over the years and watching them in their craft (indirectly and directly now) and witnessing the results, I find that to trade on their calls to be hazardous to one's wealth. However, I think they really get to know "their" companies and I admire their deep knowledge of the companies that they follow. Unfortunately, knowing their companies does not translate well into making profitable trading decisions.

    1. I agree. Good anaylsts really know their industry and companies they cover. If you know what you are looking for, analysts are very useful. It's just the EPS and short term guessing that is pretty much impossible that they are forced to do. When I was in the business, the large mutual fund companies demanded our analysts' spreadsheets and earnings models so they can update EPS forecasts more quickly with new data points (so they don't have to wait for analyst revisions).

      That's how short-term even the mutual fund industry became; they only cared about the next quarter's EPS.

      That's precisely one of the biggest problems. The greatest, most knowledgable baseball expert can be useful and can teach you a lot about the players, teams and whatnot. But that doesn't mean he can sit their and guess if A-Rod is going to hit a home run, a single, double or strike out on the next at-bat. But that's sort of what Wall Street analysts are expected to do.

      So it's often not really the analysts' fault that they look so bad...

  4. That's a nice model. No one is irrational! Not the conservative value guys, not the ones help who run their companies to the ground. Gotta love that.

  5. Great article! Nice description of the elephant in the investment industry nobody wants to talk or hear about.

  6. Thanks for sharing another good article. A question I have is what about hedge funds? Do they have any of these biases that would hurt the investor in them? In theory, the 2+20 incentive should cause their incentives to become better aligns. However would the 2% mgmt fee drive them to be asset gethers that are willing to forgo the 20% incentive?

    1. Yes, I think it exists in the hedge fund world too, but maybe not to the same extent. Mutual fund money can be pretty sticky whereas there is a lot of fast money in the hedge fund world (fund of funds, institutional client base etc.).

      Back in the 80s and 90s, a hedge fund wouldn't even have been considered if they didn't return 30-40%/year. And the funds that did that were much smaller. $500 mn, for example.

      So you can do the math. You can generate 40%/year returns on $500 mn for 2/20, but what about getting $10 billion AUM and generating 10-15% returns? The math is simple.

      Some of that is that institutional investors started to demand lower but more consistent returns and maybe another factor was that the hedge funds became bigger as organizations and wanted more management fees to cover the increasing fixed costs to stabilize their business.

      So there were other factors. But still, it's not to the same extent as mutual funds which just advertise, market and make money like that (not to mention paying brokers to sell funds for big fees).

      Look at a typical mutual fund family and see how many funds they have. It works out great because the more funds you have, the more four and five star funds you will have at any given point in time. So whereever you are in the market cycle, you hopefully will always have some four/five star funds that you can feature in ads to brag about and promote. It really is a heads I win, tails I win business for them...

      Hedge funds can't do that...

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