Do Analysts Seek Safety in Numbers?

Florida Retirement System Investment Plan
August 19, 2017
Investor Risk Tolerance: Ability & Willingness
September 1, 2017

It seems to me that, when it comes to providing an investment recommendation for a difficult to value security, an easily identifiable consensus might influence subsequent recommendations. The attraction of consensus might not only perpetuate anchoring, but could also provide safety in numbers for analysts placed into, or choosing to operate within, forecasting minefields.

Exhibit A

Odds are, if you’re reading this, you’re familiar with the internet. If this is true, then there is a fair chance that you’ve utilized one of the growing list of services provided by, or through, a company called Amazon.com; whether you realized it or not.

Amazon.com (Ticker: AMZN) is a huge company. Presently, Amazon.com is the fourth largest company by market capitalization in the U.S., and one of largest companies in the world. Given its relative heft – not to mention the impact the company has on so many industries – it’s easy to understand why so many eyes are closely watching the comings and goings of this juggernaut of our modern era.

Among those keeping tabs on Amazon.com are a multitude of securities analysts. I would imagine that the public will never lay eyes on the majority of the work produced by analysts evaluating the company’s current and future prospects, because the work of so many analysts will be reserved for the internal consumption of the company that hired them. Others, however, disclose the product of their research in the form of an explicit investment recommendation or price target. It is the latter group that interests us now.

When public investment recommendations are made, they are open to scrutiny. It is not my purpose to scrutinize individual investment recommendations, but the availability of these recommendations provide us with an interesting opportunity at this moment to conduct an informal experiment. Amazon.com, and those following the company, provide us with the necessary ingredients.

A Little Context

Amazon.com has long been difficult to evaluate from an equity analyst’s perspective. If the end goal is to produce a price target or investment recommendation, the easiest companies to evaluate might have a long history of fairly consistent cash flows (ideally producing net earnings), a clear picture of current and anticipated debt, and, if applicable, dividends. Amazon.com, since its infancy, has possessed pretty close to the opposite of these attributes.

Amazon.com has expanded its presence across the U.S., and even globally, at a breakneck pace; exponentially increasing revenue along the way, but often increasing expenses just as quickly, if not more quickly. The company is not immune from periodic net losses, which is truly impressive considering the outflows required to outweigh its staggering revenue (current and previous financial statements are publicly available via SEC.gov). Regardless of the company’s less than flawless record producing positive earnings per share, its stock price has been a sight to behold since it started trading just over twenty years ago:

To make matters a little more difficult for those analyzing it, it doesn’t really fit into any one industry all that well. Is it a retail company? Is it a technology company? A logistics company? An advertising company? A multimedia company? A grocer?! Yes!

The company’s influential tentacles reaching into so many business categories makes relative valuation particularly tricky. In other words, it’s hard to look at – or find – a comparable company’s, or companies within a comparable industry’s, stock price and underlying financial information to evaluate the appropriateness of Amazon.com’s stock price relative to its peers.

In short, it is not easy to come up with a reliable price target for a company like Amazon.com. Developing a recommendation – that isn’t just based on past price movement – for a stock like this requires a lot of assumptions. Depending on the variable, if any one of those assumptions is inaccurate, the underlying financial condition of the company will eventually be drastically different than forecasted.

Confidence or Something Else?

My point in mentioning how difficult it is to evaluate the stock price of a company like Amazon.com is that one would think that any sample of analysts’ opinions would be heterogeneous. That is, one might expect that targets and, consequently, investment recommendations produced by professional analysts would reflect some variety.

Imagine my surprise when a colleague pointed me in the direction of the Analyst Estimates section of Amazon.com’s profile page on a popular consumer finance site, MarketWatch.com, and found that, out of 44 analysts reporting, 34 produced a “Buy” recommendation, and one produced a “Sell” recommendation. (The recommendations of the remaining analysts included four for “Overweight,” five for “Hold” and none for “Underweight.”)

Is there really that much confidence that the stock of Amazon.com should be purchased at its current price, and/or might there be something else at play here?

The Gravity of Consensus?

While I cannot be certain – and this is, therefore, my opinion – I do wonder if the accumulation of estimates at one end of the spectrum has created something similar to a gravitational pull. I imagine this force increasingly affecting the analysis of other professionals as the weight of additional recommendations are added to consensus.

An analyst tasked with valuing a popular but hard to value company, and expected to produce a recommendation other than “hard to say,” is in a difficult spot. In the case of Amazon.com, with the stock price continuing to rise for so long, often in the face of contradictory traditional fundamental valuation, it might be a risky endeavor, career-wise, to bet against a winning horse. This seems particularly true if so many of one’s professional peers seem to concur that the stock is, if nothing else, not overvalued to point of diminishing future returns.

If a dissenter is wrong, they might look foolish. Conversely, if an analyst biases their analysis to resemble the consensus – intentionally or otherwise – and the consensus ends up being wrong, then there might be safety in numbers. It would be difficult to fault someone’s process or judgement if the majority of other professionals applying their respective brands of process and judgement came to the same conclusion. Right?

An Observational Experiment

My hypothesis is that the tightly grouped consensus that presently exists among the analysts recorded by this particular media outlet will become more diverse, but too late to matter. That is, I think that if Amazon.com’s price experiences a break from its generally upward trend, analysts tightly grouped around the current “Buy” consensus would begin to reflect what I believe is the more intuitive – given the difficulty forecasting for a company such as Amazon.com – dispersion across the spectrum of recommendations in question.

What makes this experiment interesting – to me anyway – is that I believe that this shift in analyst sentiment will only happen once the price of the stock has already declined substantially. If this is the case, it might illustrate that the currently heavy “Buy” recommendation is, perhaps, influenced, at least in part, by a desire to conform to consensus.

Of course, in order to test this hypothesis, the price of Amazon.com’s stock will have to decline substantially at some point. Given my original expectation that analysts’ recommendations pertaining to this security would be more diverse, I believe that the decline necessary for our experiment should not be outside the bounds of reality.

Although I encourage readers to follow along themselves, it is my intention to circle back around in six and twelve months to see if we can glean anything from our observations. Not that our casual experiment will prove anything, in the meantime, investors might at least consider the possibility that factors other than those directly related to a company itself might influence investment recommendations, and perform their own due diligence accordingly.

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