Equity Analysts Still Too Bullish

After almost a decade of stricter regulation, analysts’ earnings forecasts continue to be excessively optimistic.

McKinsey Quarterly

APRIL 2010 • Marc Goedhart, Rishi Raj, and Abhishek Saxena

No executive would dispute that analysts’ forecasts serve as an important benchmark of the current and future health of companies. To better understand their accuracy, we undertook research nearly a decade ago … . Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.¹

…[A] recently completed update of our work …reinforces this view—despite a series of rules and regulations … that were intended to improve the quality of the analysts’ long-term earnings forecasts, restore investor confidence in them, and prevent conflicts of interest.² For executives, …this is a cautionary tale worth remembering.

Exceptions to the long pattern of excessively optimistic forecasts are rare, as a progression of consensus earnings estimates for the S&P 500 shows (Exhibit 1). Only in years such as 2003 to 2006, when strong economic growth generated actual earnings that caught up with earlier predictions, do forecasts actually hit the mark. This pattern confirms our earlier findings that analysts typically lag behind events in revising their forecasts to reflect new economic conditions. When economic growth accelerates, the size of the forecast error declines; when economic growth slows, it increases.³ …

Moreover, analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year,⁴ compared with actual earnings growth of 6 percent.⁵ Over this time frame, actual earnings growth surpassed forecasts in only two instances, both during the earnings recovery following a recession (Exhibit 2). On average, analysts’ forecasts have been almost 100 percent too high.⁶

Capital markets, on the other hand, are notably less giddy in their predictions. Except during the market bubble of 1999–2001, actual price-to-earnings ratios have been 25 percent lower than implied P/E ratios based on analyst forecasts (Exhibit 3). What’s more, an actual forward P/E ratio⁷ of the S&P 500 as of November 11, 2009—14—is consistent with long-term earnings growth of 5 percent.⁸ This assessment is more reasonable, considering that long-term earnings growth for the market as a whole is unlikely to differ significantly from growth in GDP,⁹ as prior McKinsey research has shown.¹⁰ Executives … ought to base their strategic decisions on what they see happening in their industries rather than respond to the pressures of forecasts, since even the market doesn’t expect them to do so.

About the Authors

Marc Goedhart is a consultant in McKinsey’s Amsterdam office; Rishi Raj and Abhishek Saxena are consultants in the Delhi office.

Notes

¹ Marc H. Goedhart, Brendan Russell, and Zane D. Williams, “Prophets and profits,” mckinseyquarterly.com, October 2001.

² US Securities and Exchange Commission (SEC) Regulation Fair Disclosure (FD), passed in 2000, prohibits the selective disclosure of material information to some people but not others. The Sarbanes–Oxley Act of 2002 includes provisions specifically intended to help restore investor confidence in the reporting of securities’ analysts, including a code of conduct for them and a requirement to disclose knowable conflicts of interest. The Global Settlement of 2003 between regulators and ten of the largest US investment firms aimed to prevent conflicts of interest between their analyst and investment businesses.

³ The correlation between the absolute size of the error in forecast earnings growth (S&P 500) and GDP growth is –0.55.

⁴ Our analysis of the distribution of five-year earnings growth (as of March 2005) suggests that analysts forecast growth of more than 10 percent for 70 percent of S&P 500 companies.

⁵ Except 1998–2001, when the growth outlook became excessively optimistic.

⁶ We also analyzed trends for three-year earnings-growth estimates based on year-on-year earnings estimates provided by the analysts, where the sample size of analysts’ coverage is bigger. Our conclusions on the trend and the gap vis-à-vis actual earnings growth does not change.

⁷ Market-weighted and forward-looking earnings-per-share (EPS) estimate for 2010.

⁸ Assuming a return on equity (ROE) of 13.5 percent (the long-term historical average) and a cost of equity of 9.5 percent—the long-term real cost of equity (7 percent) and inflation (2.5 percent).

⁹ Real GDP has averaged 3 to 4 percent over past seven or eight decades, which would indeed be consistent with nominal growth of 5 to 7 percent given current inflation of 2 to 3 percent.

¹⁰ Timothy Koller and Zane D. Williams, “What happened to the bull market?” mckinseyquarterly.com, November 2001.

Advice restrictions expected

Rejection of Bush-era rule signals tougher regs ahead

Pensions & Investments

By Jeff Nash September 21, 2009, 12:01 AM ET

Industry experts expect a more restrictive investment advice proposal later this year now that the Labor Department has killed a Bush administration regulation on advice to DC plan participants.

The rule, floated in the last days of the Bush administration, would have allowed employees of financial firms that sell investments to provide direct advice to defined contribution plan participants. …

While it's unclear what the new investment advice proposal will say, many experts agree that the Labor Department will work with Congress to find a way for plan participants to receive objective investment advice. As part of that process, Phyllis Borzi, assistant secretary of the Labor Department and head of the Employee Benefits Security Administration, will likely solicit wide-ranging opinions to re-examine three core topics:

• Should the “fee leveling,” condition — which would permit an employee of a financial services firm to offer investment advice directly to DC plan participants if his compensation doesn't vary based on the investment recommendation — be extended to that adviser's employer, as well as any affiliate of that employer? This effectively would prevent money managers from offering advice if they recommend their own products.

• Should new legislation support or invalidate the Department of Labor's 2001 SunAmerica advisory opinion, which allows a DC plan's service provider to offer advice to plan participants through an affiliated adviser using an independently developed computer model?

• Should “off-model” advice be permitted? In other words, can a mutual fund or investment management company design its own computer software to deliver advice, as long as the model is certified as unbiased by an independent third party.

… The EBSA is expected to release new proposals on Nov. 18 — the date the Bush investment advice rules would have taken effect after two delays. …

Pro-participant

“I think Phyllis wanted a tabula rasa, and the only thing for certain is that the new rules will be pro-participant,” said Marcia Wagner, an ERISA attorney with Wagner Law Group PC, Boston. “She may well come up with something never thought of, something completely different. Remember this is the woman who basically created COBRA; she's extremely creative.” …

[Rep. Robert Andrews (D-N.J.), chairman of the House Education and Labor Committee's pensions subcommittee],explained the 2006 Pension Protection Act would have to be changed in order for the DOL to issue the kind of investment advice rules Congress would support. “It will take statutory and regulatory change to create the goal of qualified-independent-investment advice affordable to every investor,” he said.

One major area to be considered is what is meant by “fee leveling.” …

… Many experts expect the new proposals also will address the SunAmerica opinion.

“We need to see some clarification and formalizing of this rule, which really avoids conflicts of interest for advisers and ensures some independence,” said Robyn Credico, director of the plan management group practice, North America, at Watson Wyatt Worldwide Inc., Arlington, Va.

But if the Labor Department reverses the opinion, that could force employees to use independent advisers. “Not everyone can use truly independent advisers because they're expensive,” Ms. Credico said.

Questions of scope

Jason Bortz, an ERISA attorney with the law firm Davis & Harman LLP, Washington, said “some people have raised questions about the scope of the SunAmerica opinion — for example, whether a model should take into account non-proprietary funds.”

In July, the House Education and Labor Committee approved the 401(k) Fair Disclosure and Pension Security Act of 2009, which was sponsored by Messrs. Miller and Andrews. The legislation would prohibit employees of financial services firms from offering investment advice if their compensation varies depending on the investment advice they give. …

Another option the Department of Labor might consider is allowing mutual funds and other investment companies to offer advice through their own computer model that has been certified as unbiased by a third party — an idea originally floated in a bill introduced by Mr. Andrews back in May.

Contact Jeff Nash at jnash@pionline.com

Understanding the minds of retirees

A little knowledge about behavioral finance goes a long way in tough economic times

Investment News

By Michael M. Pompian May 21, 2009, 10:05 AM EST

Understanding how retiree investors are apt to behave can help advisers manage relationships during difficult market environments. …

To help advisers, I've identified four common behavioral investor types, or BITs, that reflect the patterns in which most people react to their environment.

Before we get to specific BITs, though, let's review the two types of biases that appear in all investors: cognitive and emotional.

A cognitive bias is a statistical, information-processing or memory error common to all human beings. Think of these errors as “blind spots” or distortions in the rational human mind.

Emotional biases, which are on the other end of the spectrum, are expressions — often involuntary — related to feelings, perceptions or beliefs that can exist in reality or in the imagination.

Often, because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult for an adviser to correct. Among the BITs I've identified, the least risk-tolerant are conservative investors I call passive preservers, who are mostly emotionally biased in their behavior.

There are many of these among advisers' retiree clients, so let's review their biases along the cognitive/emotional divide and consider how best to advise them.

Emotional biases:

• Loss aversion. Compared with others, conservative investors tend to feel the pain of losses more than the pleasure of gains. They often hold losing investments too long even when no prospect of a turnaround is in sight. …

• Status quo. Conservative investors often like to keep their investments … the same. They tell themselves that “things have always been this way,” and feel safe keeping things unchanged.

• Endowment. Conservative investors, especially clients who inherit wealth, tend to assign a greater value to investments that they own (such as a piece of real estate or an inherited stock position) than potential investments.

• Regret aversion. Conservative investors often avoid taking decisive actions, because they fear that in hindsight, whatever course they select will prove less than optimal. Regret aversion can cause them to be too timid in their investment choices because of losses they have suffered.

Cognitive biases:

• Anchoring. Conservative investors often are influenced by purchase points or arbitrary price levels. They tend to cling to these numbers when facing questions such as, “Should I buy or sell this investment?” Suppose that a stock is down 25% from a high it reached five months ago. A conservative client may resist selling until the price rebounds fully.

• Mental accounting. Conservative clients often treat various sums of money differently, based on where those sums are mentally categorized. They may segregate assets into safe and risky “buckets.” But if all assets are viewed as safe money, suboptimal returns usually result.

As you can see, the behavioral biases of conservative clients are largely emotional. …

…[Focus] on how investment decisions affect issues that are emotionally important, such as family, legacies and lifestyle, and try to empathize with what clients are experiencing.

When working with conservative investors, look for these biases and advise clients accordingly. Understanding your client's behavior leads to better communication and a clearer understanding of the motivations behind investment decisions — and hopefully a better client -relationship.

Michael M. Pompian, a chartered financial analyst and certified financial planner, is director of the private-wealth practice at Hammond Associates, a St. Louis-based investment -consulting firm with $50 billion under advisement.