Proposed Bi-Annual Change May be Better Served in Equity Research, Not Quarterly Results
Recently, President Trump tweeted about having the Securities and Exchange Commission (SEC) investigate whether it may be better to have companies report bi-annually versus the current quarterly reporting structure. We’re not sure a change to bi-annual earnings is the best method to develop longer-term focus in financial markets. In our opinion, management can still “spin” or “massage” results whether reporting every three months or six months. Quarterly updates allow management to provide investors short-term “mileposts” on their journey toward the company’s long-term vision, but we believe it is the market that utilizes this data to form more short-term views. “Short-termism” from companies can perhaps be controlled better by reducing compensation tied to stock price or regulating buybacks by locking up executives from selling. However, we do believe that the President may have been on to something.
What may be better served by bi-annual updates might be equity research. The change we propose would allow analysts to update ratings and price targets two times per year, which may force analysts to take a longer-term focus in their ratings, and proposed price targets, of covered companies. In our opinion, the financial markets shift toward a more short-term focus is highly correlated to whipsaw changes in equity valuation or near-term business outlook from equity research. Historically, these bi-polar changes were a mechanism for firms to derive trading compensation and revenues, but given the change in recent years by many investment firms toward fixed payments for equity research, we wonder why equity research hasn’t changed to a more long-term focused product.
Does a Company’s Long-Term Outlook Truly Change Quarter by Quarter?
We don’t believe a company’s long-term outlook, or perceived valuation, really changes quarter to quarter. Certainly, there are always exception to this rule, as in anything, but for the majority of public companies we don’t believe long-term value changes every three months. This was not the view I previously held as an equity analyst, however, my view has evolved since leaving Wall Street. While working internally at two leading public technology companies, I was able to realize that actual changes in business dynamics take much longer to play out, either positively or negatively. For example, in today’s financial markets, if a company were to miss its reported earnings per share (EPS) by $0.01, or a few million dollars in quarterly revenue, it could potentially create a dynamic which changes the assessed valuation by double digit percentages. But let’s look at how it should actually impact a company’s longer-term valuation. Assuming a company trades at a forward price-to-earnings multiple of 20x, a miss of $0.01 in quarterly results should equate to a reduction in forward value of $0.20, or if you want to extrapolate it out annually, perhaps $0.80, but quite often it can create value deterioration equal to multiples of this figure. Based on one quarter of earnings has the company’s long-term value or competitive position really changed during the quarter in which it may have missed analyst estimates? Or did other factors impact results, such as analysts and investors ratcheting up expectations during the quarter, which may have changed the financial markets’ view of potential earnings power for that specific quarter. Shifting equity research to bi-annual updates, which would require looking at company’s performance or valuation on a bi-annual basis, and having two quarters of business performance to review, may lead to a longer-term view of the valuation of company’s business prospects.
Bi-Annual Updates Likely Demonstrate Analyst’s Fundamental Understanding of a Company
By allowing only bi-annual updates within equity research, analysts would have the ability to stay with their outlook or change their outlook, following 2 quarters of business performance. This would likely provide better information regarding how the company’s outlook for the full fiscal year has progressed or if any potential shortfalls are likely to be a headwind for the upcoming next six months. This type of change would require a more thoughtful analysis of equity valuation, target prices, and ratings. While we acknowledge there are many analysts who already may employ this proposed change in their current equity analysis, we believe many analysts simply whip their ratings and target prices around, suggesting the overall prospects of a business can at times change two, three, or multiple times during the course of a fiscal year.
A recent example we wanted to highlight, which demonstrates why our proposal may improve the longer-term focus on equity research, was a reduction in price target on shares of Tesla (NASDAQ: TSLA). I don’t know the analyst referenced but found the change in the firm’s short-term price target to be a perfect example of why we believe a change is merited in an analyst’s ability to adjust stock ratings and price targets.
An investment bank on Monday reduced their price target for shares of Tesla (NASDAQ: TSLA) back to $195, down from $308. What is unique in this call is that the investment bank recently raised their price target for shares to the $308 from the firm’s prior target of $195 only about two weeks prior. We would note, even more puzzling is that the analyst kept the firm’s Underweight (SELL) rating even during the firm’s significant swings in forecasted share valuation. Under the changes we propose, which would limit changes in analyst ratings and price targets to every six months, the analyst covering Tesla (NASDAQ: TSLA) would have been required to stick with the firm’s first price target of $195, and Underweight (SELL) rating. The original rating and price target clearly suggested the analyst believed investors should have been selling Tesla (NASDAQ: TSLA) shares short based on what we hope was the analyst’s long-term view of the company’s potential risks and upside over the next 12 months. While we recognize that the infamous tweet from CEO Elon Musk about going private may have changed the potential long-term value of TSLA, if in fact it were true, it is our view that if the analyst believed a 40%+ decline was likely prior to this event, the analyst should have likely considered all the factors which could have worked against the rating and price target in the next six months, suggesting such a significant decline in shares was the most likely outcome. It is our belief, applying our proposed change may have made the analyst potentially less aggressive in the firm’s negative view of Tesla (NASDAQ: TSLA) and the long-term value offered by its business versus the implied 40%+ plus decline the firm’s original price target suggested. Did the long-term value of Tesla’s (NASDAQ: TSLA) business change by 58% two weeks prior based on the increased price target of $308, and then decline again by more than 35% when the target was reduced back to $195? Perhaps some would say yes, based on the CEO’s tweet. However this change, if true, would have highlighted the incorrect view this analyst held regarding shares of Tesla (NASDAQ: TSLA), and in the eyes of investors may have removed credibility from the analyst for future calls.
Under our proposed changes to equity research, the analyst we highlighted in our example could have changed the rating mid-year (late June/early July time frame) but would be stuck with either a new more positive rating, and corresponding target price, or maintain the previous outlook for the next six months. Given the dramatic swings in perceived valuation by the covering analyst we have highlighted, we don’t think changes were primarily made based on fundamental business value, and thus we believe the analyst should be stuck with their view at the mid-year point, which should have accounted for both upside and downside risks for the long-term value of the company.
A change in an analyst’s ability to update ratings or price targets would allow investors to see which analysts have a true fundamental understanding of the company over the long-term and may potentially provide higher value for their views related to the company. We believe a change such as we have proposed could help increase the value companies are willing to pay for equity research, which has been diminishing annually for the last decade. A change to bi-annual rating changes would allow analysts with a fundamental understanding of the longer-term value of a business to demonstrate their knowledge, and not provide unlimited “flexibility” for analysts to swing their proposed stock ratings or long-term company valuation.
Potential Push-Back Regarding our View of Proposed Changes to Equity Research Updates
Undoubtedly, we believe there may be significant objection or pushback to our hypothetical changes to equity research. Thus, we try to answer some of the pushback we believe may arise to counter why our proposed changes may not be the best solution. We acknowledge that there may be flaws in our proposal but want to highlight the need for equity research to shift towards a more long-term view.
Objection: Business models are fluid and thus changes may be necessary to the analyst’s investment thesis. We agree that dynamics in business are in fact fluid and can change. However, we believe that more thoughtful analysis and a more rigid system related to price targets and ratings will likely bring more thought into the risks of a positive or negative rating for shares over the next six months.
Objection: It’s easy to “Monday Morning QB” analyst calls. Having sat in the analyst seat myself, I agree that all too often it is easy for someone to sit back and attack a research call that did not play out as expected. However, by the same token, the level of “flexibility” in analyst calls, as demonstrated by our example, suggests that equity research, which drives the fundamental value of a business and its potential share price should have repercussions for analysts who are incorrect in their views, and not be given the flexibility to change these views to avoid the pain of shares working significantly against their calls and reducing their implied alpha generation.
Objection: By shifting analyst updates to only two times a year, share price volatility may significantly increase. This may be a fair challenge to our proposed view, as analysts may upgrade or downgrade shares twice a year, which could potentially lead to dramatic changes in the perceived long-term value of a company and create higher volatility twice annually. This theory, however, would assume that most analysts would be significantly incorrect in their views of the company’s long-term value and would need to materially alter their prior outlook. By the same token, we believe the intra-quarter, or quarterly volatility, that occurs today would also likely diminish. Given investors will be able to monitor the change in valuation over a six-month period, it may be easier to determine, or maybe not, if an analyst who has been incorrect may change their view, which the market would be able to prepare for in advance and thus reduce potential volatility ahead of potential rating/price target changes. Our methodology looks to make equity analysts, and the valuation/ratings they assign to companies, become more long-term oriented. Thus, the valuation of companies on stock exchanges may see less volatility and the analysts assigning the price targets and ratings may have to be more conservative in their views.
Objection: What if shares reach the analyst’s price target prior to the six-month window? Again, this could be a valid push back on our proposal, but we would also note that historically, when a price target is achieved, this has typically been a way for analysts to simply increase their price target, often with little or no change to the long-term business fundamentals. Perhaps the analyst was too conservative, or perhaps, the current system of price target revisions doesn’t reflect any real change in the fundamentals of the business, just the perceived value of shares.
Our proposal to move equity rating and price target changes to twice a year was a hypothetical effort to highlight the short-term nature of financial markets and the “flexibility” analysts covering public companies exemplify daily. Public companies, and their respective management teams, are not without fault regarding short-term views, often due more to compensation metrics. But we would also note that the historical model of equity research, which was based primarily on generating revenue from trading commissions, and thus needed to actively offer opinions and updated views, has also changed. We would challenge equity research firms, and Directors of Research, to take a longer-term view of the companies they cover. This may not generate weekly or daily research, but we believe over the long-term, these types of shifts in how research is compiled, and ratings/price targets are assigned, may increase the value of their research in years to come.