Equity research, Analysis & the recommendations

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Yesterday, I got a comment from Mahen, which is just in time with regard to this new article of mine. In his comment, Mahen has mentioned that “Most of the analysts are BULLISH on India, basically believing that Indian Success story will continue atleast for next 5-10 years, so it is worth investing in Indian equity market”
He is right, atleast about what the analysts say - 99% of the analysts are bullish on the Indian story. But who are these analysts???

Let me explain this - Every investment firm (Mutual Fund, Investment Bank, Brokerage Houses, Security Trading firms, etc.) has a dedicated team called equity research team. The members of this team are called equity research analysts - or in short "Analysts". These people try to keep track of the companies and their performance. They try to look at the CASH FLOWS of the companies and apply valuation strategies like “Discounted Cash Flow” techniques and try to calculate the future value of the stock. Following their "ANALYSIS", they arrive at a stock price which they believe is correct as per their valuation. If the Market price of the stock is lower than their calculated stock price, they give a BUY recommendation for that stock, means they think that at the present market price the share is cheap, and it will rise to its fair value (the value that they calculate). If the Market price of the stock is higher than their calculated stock price, they give a SELL recommendation for that stock, meaning the share is over-valued so sell it off, otherwise it will come down to it’s fair value.

But to whom do they give these recommendations? They work for an investment company, so obviously the recommendations are given to the other teams within their company so that they can benefit from their analysis. These recommendations are given to their Fund Managers and the traders of the investment firm. The Fund managers and traders look at the “Research Analysis” or “Research Reports” from these “Analysts” and take action accordingly. Along with these research reports, they also use their head, and take the decision of buying and selling as per their understanding. Sometimes, these research reports are offered to public for free. These analysts also predict the results of the company – viz Sales, Profit, loss, taxes, etc. each quarter.

The question is: Can these analysts be trusted? How solid is their research? Is the valuation method they follow robust enough to calculate the price accurately?

The answer is NO. Take a recent example. Reliance Industries, one of the most reputed Indian companies, before declaring its results, called for a analysts meeting. Analysts from reputed Multinational Investment firms and trading houses were invited to the meeting. They estimated reliance profits to be at a value which was much lower than the actual one. Reliance shocked them with a staggering 40% higher profit than what the research analysts had calculated. The result – immediately after the results announcement, the stock price of reliance started to increase. From the level of 1350 or so, it is now at 1700 level. This is a very recent example which shows how the research analysts fail.

Doing such research is a very subjective task: Analyzing a company means understanding its projects, understating how much investment is needed and for how long the project will run, understanding how much profit it will generate and from when, predicting how will the market respond to the product from that project, estimating market risks in terms of competitors entering the market and when, interpreting whether the project will run in foreign countries, what about currency fluctuations, etc, etc, etc, etc. You see, the list is endless – but the list contains all kinds of “ESTIMATIONS, INTERPRETATIONS, UNDERSTANDING” and similar highly skewed terms. These methods are highly error-prone.

Companies are required to publish their business results (Sales/Profit/Loss/etc) every quarter. Just before the company is about to declare the results, the analysts calculate the value of the company by trying to estimate the sales/profit/losses/etc. You may have heard this term quite often: “XYZ Company beats street expectation OR ABC Company failed to beat street expectations”. The term street expectation is a value calculated by these analysts. These analysts give their expectations about the company financials just before the declaration of the results – called STREET EXPECTATION. If the actual results of the company are better than this value, it is called “Company beats the street expectations”; otherwise “Failed to meet the street expectations”.

This brings us to another fundamental situation – why will someone give a recommendation on a particular stock, a particular industry, a particular market (means a country)? Visit the stocks section on Rediff website: http://money.rediff.com/money/jsp/markets_home.jsp. Just below the Sensex Chart on the right side, you will see a section called “Broker Tips”. At the time of writing this article, it had the following table:

Broker tips
Broking House	Company	Action	Date	Price
Sharekhan	+ Intl. Combustion	Buy	Jun 05, 07	519.00
Emkay	+ Tata Chemicals	Buy	Jun 05, 07	279.00
Macquaire Research	+ Punj Lloyd	Outperformer	Jun 05, 07	263.00
IndiaInfoline	+ Nagarjuna Constr	Hold	Jun 05, 07	182.00
Khandwala Securities	+ NTPC	Buy	Jun 05, 07	172.50

Basically, the brokerage firm, like ShareKhan, is giving a BUY recommendation on Intl. Combustion for buying at a price of 519.00, and similarly there are other tips. Similar tips and recommendations can be found on websites of other brokerage houses and investment banks (including MNCs), all available FREE OF COST.

The recommendation is coming from investment firm – my question is why these firms are telling OTHERS their investments tips? They have done the research, they have invested their time, effort, money and energy in coming up with the research report, so they should use it for their benefit. These firms have enormous amounts of money, why don’t they invest the money for themselves, why are they telling it openly?

Imagine what would you do if you buy something – say a stock or some crop or some other goods - which you decide to sell later at a higher value to make profits. What would you do, you will start spreading all good things about the stuff that you’ve bought. You want the price of that to increase, which ultimately happens if the demand for that stuff increases, which will happen if more people know that this stuff is good. The same thing goes on in the finance world. The investment firms that give recommendations are for the stocks that they have already invested in. They want the price of that stock to go up – so they give a BUY recommendation. People who believe on them, start buying the stock, the demand goes up, so does the price. The investment firm then sells off its holdings at a higher price, and makes good money. The investors, who buy this stock at higher price, then have to wait, claiming that “I’m a long term investor, in the long term, this stock will appreciate”; sit back and relax.
The opposite happens when an investment firm wants to BUY a stock. They issue a SELL recommendation. The investors who believe them start selling the stock, the supply rises and the prices fall. The investment house then buys the stock at a lower price. And the game continues.

The basic fact for research and analysis is: If I know something is good, why will I tell it to others? I will tell it to others only to get the benefit for sharing the secrets publicly. The way it is done is explained above.

These were the same analysts from reputed investment firms- who could not predict the internet bubble burst in 2000. Forget about 5-10 years long horizon, the analysts were giving BUY recommendation on every single dotcom stock in 1999 – claiming it to be a multibagger. Within a year, in 2000, all the dotcoms went burst. In India, television started gaining popularity since 1985. Analysts predicted it to be the end of the radio industry. However, after 20 years, radio industry in India is bouncing back significantly, such that majority of the mobile phones available today come with an inbuilt FM radio. Did anyone get a BUY recommendation on media stocks before the onset of radio industry? The answer is NO. Did anyone give any recommendation on the airline stocks before the consolidation started happening in the Indian Airline Industry – NO. Did any analyst give a SELL recommendation on Infosys stock in 1999 just before the slowdown in the IT industry – NO. Did anyone predict the strength in Indian Rupee against the dollar and gave opposing recommendations for Oil companies (ONGC, HPCL, etc.) & IT companies (Infy, Wipro, Satyam)? Did any analyst give recommendation in the fall back in Real Estate sector due to rising interest rates? Sometimes they do, but by the time the common men takes action on the advice, the action has already happened, the price significantly rises/falls and all the individual is left with is a loss making investment.

A very simple example can be quoted here: With the advances of medical science, people are living longer. When they live longer, there is a need for medical facilities. Isn’t this reason sufficient for a LONG TERM INVESTOR to buy pharma and hospital stocks? If this is a simple and robust reason, why don’t the fund managers keep significant portion in pharma or hospital stocks? The fact is that innovation and consolidation keeps happening. Technology moves at a rapid pace: A magic drug manufactured today can be out of the business (and its pharma company) within no time, if another better version is developed by a competitor. What prediction can anyone make about the development, research, advancement, market response, competitors product of a particular company or industry. All the task that analysts do is either look at PAST results (balance sheet of the company) and give FUTURE recommendations OR try to GUESS the project cashflows, and make predictions. How correct they are – merely depends upon their luck. Who ends up being a fool are the people who become victims of their recommendations.

Coming to the Indian story, let’s look at it from the root level. If you are believing the comments on the Indian story, it is mainly driven by the middle class salary rise. All are aware that this rise is mainly constituted by the IT sector – how long can people in Indian IT sector keep their jobs? Already, companies like British Energy have scrapped their BPO operations in India and taken back the work to their own country. A very honest article about the reality and trustworthiness of the GREAT INDIAN IT INDUSTRY is available at http://in.rediff.com/money/2004/mar/03guest1.htm How long will the Indian story continue, no one knows. Even Indian companies like Infy, Wipro, Satyam have opened up offices in China, Russia, Romania, Czech Republic, Canada, Philippines, Thailand, etc. If the work can be outsourced to India, it can as well be taken away to another country. It took only 2 years for outsourcing to become a buzz word; it may take much less than that for the work to be taken away. At that point of time, there will be no rising salaries, no spending power, no extra money, and hence no demand and affordability for new houses or cars or visits to shopping malls. When will it happen, no one knows, but if it happens, things will come done tumbling. The great Indian Software engineers proudly submit their pay slips, take house loans, car loans for big amount – completely missing the crux of the point that everything is dependent on their salary, which comes from a HIGHLY RISKY job. If they loose the job, they loose their salary, they loose their house, car, everything. You talk about boom in real estate, or boom in the retail market, or hike in car/bike sales, all coming from the extra spending power from the emerging middle class-which is driven by the software salaries. Sometimes I wonder what other job a software engineer can take up if unfortunately he looses his job. Everyone is relying on the Indian Story, mainly dependent on the foreign money from IT industry – how long it will continue, only time will tell. Rupee-Dollar rate has already hit the IT sector, same is being reflected in other sectors as well. We’ve already seen the slowdown in Indian IT sector in 2000 to 2002 period; still people don’t realize the ground realities. It’s a risky job and a risky Indian story, plan your finances properly and especially your investments. More on personal finances in a later article.

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