New York – Following up on a McKinsey & Co. study we mentioned last week, a Financial News article by Liam Vaughan and Elizabeth Pfeuti has expounded on the idea that equity analysts are too optimistic in their growth estimates. The article comments that even though the McKinsey study only focused on the US, a similar phenomenon can be seen in Europe as well. The article also mentioned that the only time analyst’s estimates were on target was during periods of strong economic growth. In recessions, analyst estimates are even more off the mark.
The original McKinsey & Company study stated that equity research analysts on the whole are close to 100% too optimistic in making their average growth predictions. Analysts overall generally predict growth rates of 10%-12%, while the actual growth experienced is closer to 6%.
Some believe that the reason analyst estimates are so optimistic is because of the inherent conflicts in the investment banking model. They believe that analyst’s sole purpose is to “drive sales”. If this is the case then nothing has changed despite the financial regulation of the early millennium (Reg FD, Sarbanes-Oxley, and the Global Settlement).
Others believe that the high expectations of the analysts is simply a factor of them getting carried away after focusing on a specific stock or sector for too long. As Steve Berexa of RCM states, “Soon a reasonable person’s upside scenario turns into everyone’s base case”.
Whatever the reason behind the aggressive analyst estimates, the real crux of the issue is what investors will do to compensate. The Financial News article mentions that most investors are savvy enough to take the analyst’s forecasts with a grain of salt, and indeed as we mentioned last week, investors already seem to be paying more attention to economic data than analyst estimates as the S&P 500 is trading at 12 times forecasted earnings, versus the historical level of 14.7. If indeed the over optimism of analysts’ forecasts is caused by conflicts, another place to turn is the independent research providers.