Thursday, 4 August 2016

A Random Walk Down Wall Street - Part Two 3: How the Pros Play the Biggest Game in Town

Chapter 8. How good is Fundamental analysis?

Two opposing views about the efficacy of fundamental analysis. Wall streeters feel that fundamental analysis is becoming more powerful and skillful at the time. People in the academic community have argued that fund managers and their fundamental analysts can do no better at picking stocks than a rank amateur.

1. Analysts can’t predict consistent long-run growth because it does not exist.

2. The careful estimates of security analysts do little better than those that would be obtained by simple extrapolation of past trends, which we have already seen are no help at all. Indeed, when compared with actual earnings growth rates, the five-year estimates of security analysts were actually worse than the predictions from several naïve forecasting models.

3. Of course, in each year some analysts did much better than average, but no consistency in their pattern of performance was found. Analysts who did better than average one year were no more likely than the others to make superior forecasts in the next year.

4. Five factors that help explain why security analysts have such difficulty in predicting the future:

a. The influence of random events.
b. The production of dubiously reported earnings through “creative” accounting procedures by companies.
c. The basic incompetence of many of the analysts themselves.
d. The loss of the best analysts to the sales desk or to portfolio managements
e. The conflicts of interest facing securities analysts at firms with large investment banking operations: to be sure, when an analyst says “buy” he may mean “hold”, and when he says “hold” he probably means this as a euphemism for “dump this piece of crap as soon as possible.”

Researchers found that stock recommendations of Wall Street firms without investment banking relationships did much better than the recommendations of brokerage firms that were involved in profitable investment banking relationships with the companies they covered.

5. Many at the funds are the best analysts and portfolio managers in the business. However, investors have done no better with the average mutual fund than they could have done by purchasing and holding an unmanaged broad stock index.

6. There are many funds beating the averages – some by significant amounts. The problem is that there is no consistency to performances. Many of the top funds of the 1970s ranked close to the bottom over the next decade.  The ability of mutual fund managers to time the market has been egregiously poor. Fundamental analysis is no better than technical analysis in enabling investors to capture above-average returns.

8. The board (semi-strong and strong) forms of the efficient-market theory: The “narrow” (weak) form of the theory says that technical analysis looking at past stock prices is useless. The “board” forms state that fundamental analysis is not helpful either. Fundamental analysis cannot produce investment recommendations that will enable an investor consistently to outperform a strategy of buying and holding an index fund. The efficient-market theory does not state that stock prices move aimlessly and erratically and are insensitive to changes in fundamental info. On the contrary, the reason prices move in a random walk is just the opposite: the market is so efficient – prices move so quickly when new info does arise – that no one can consistently buy or sell quickly enough to benefit. And real news develops randomly, that is, unpredictably.

9. The author’s view is between the pure academic view (pros cannot outperform randomly selected portfolios of stocks with equivalent risk characteristics) and the view of investment managers (professionals certainly outperform all amateur and casual investors in managing money). I believe that investors might reconsider their faith in professional advisers, but I am not ready to damn the entire field.

10. I worry about accepting all the tenets of the efficient-market theory, in part because the theory rests on several fragile assumptions. The first is that perfect pricing exists. We have seen ample evidence that stocks sometimes do not sell on the basis of anyone’s estimate of value – that purchasers are often swept up in waves of frenzy. Another fragile assumption is that news travels instantaneously. Finally, there is the enormous difficulty of translating known info about a stock into an estimate of true value.

A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel

No comments: