How to demystify market prophets

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Sales and profit forecasts from City analysts play an important role in determining share prices. These estimates are available to professional investors through specialized electronic databases offered by Bloomberg, Refinitiv and others.

Typically, companies that perform better than expected see their share prices rise, and companies that don’t do so suffer. Siemens, the €126 billion German industrial conglomerate, on Wednesday raised its sales and earnings outlook for the fiscal year ending September 2023. It now expects earnings per share of up to €9.90, up from 5 .47 euros from last year. Its stock price duly soared.

But this behavior doesn’t always hold up. It may be a bad idea to take these projections at face value. Private street investors know there is an art to reading them. More to the point, the aggregate of those estimates may not be an accurate predictor of how the market as a whole might do.

For a clear example of why relying on published estimates isn’t always a good strategy, look no further than Q1 2023. One quick look at the numbers reported and you’d be justified in thinking that companies performed much better than their peers. market expectations: and that stock prices could explode. Not like that.

First-quarter earnings beat analyst forecasts by an average of 14%, according to Deutsche Bank. Companies also seemed optimistic about the future. A Barclays analysis of conference call transcripts found that 70% of companies see profit margins maintaining or even expanding.

Yet all these positive surprises have failed to give markets much momentum. Both the S&P 500 and the Euro Stoxx 600 are trading roughly where they were in February, before the brief banking-related swing.

This suggests that savvy investors had already applied a healthy dose of skepticism to analyst forecasts. And, indeed, it’s not hard to see why they might have done it.

Overall, analysts had expected a 12% drop in first-quarter profits compared to last year’s first quarter. Yet resilient macroeconomic data has long suggested that this may be overly gloomy. Energy costs across Europe are falling, with natural gas not far from two-year lows. UK GDP numbers performed better than feared. Recent releases of the Purchasing Managers’ Index for Europe have revealed a trend of rising confidence.

The top-down macro mood music provided a more useful indicator than bottom-up earnings consensus. This points to some of the reasons why analyst estimates, while important, are flawed.

Analysts can be late to the party, often releasing estimates only about once a quarter. At any point in time, the consensus reflects a mix of current and old numbers. Furthermore, analysts tend to focus – in detail – on short-term estimates. The medium-term outlook, which reasonable investors should focus on, can be roughly outlined.

Second, taking all analyst estimates in aggregate can give a misleading view of the market as a whole. Sum of all company forecasts outpaces GDP growth by some margin, suggests US stock market analysis by Verdict.

Still, analysts provide a useful service, especially when looking at individual companies. Listed groups want to be well understood by the market and lead the analyst community on how to shape future trends. The best of analysts can use this understanding to pick stocks that will outperform, relative to the rest, according to a study by Hemang Desai and others for the Financial Analyst Journal.

But the lesson for investors is that, as a broader indicator of where markets are heading, published estimates should be taken with a shovel of salt.

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Vodafone: Margherita’s recipe

What analysts understand well is how much a company’s assets can be worth. In the case of Vodafone, they believe that the value of the constituent parts exceeds the market capitalization of the telecom group by a certain margin. This suggests that the group’s new chief executive, Margherita della Valle, will come under pressure to put them on the block.

This doesn’t seem to be his plan. Of the valley last turn it is a pragmatic response to competitive weakness. But it’s unlikely to give anything close to the value of the group on a sum-of-the-parts basis. That helps explain why the market slashed Vodafone’s shares by 7% when the plan was revealed on Tuesday.

Vodafone operates in a fiercely competitive European market and has an accompanying tendency to use the foot for target practice. It has stumbled in Spain and, spectacularly, in Germany, its largest market, where it is losing broadband customers.

Revenues have been essentially flat for at least a decade. Returns lurk below or around the cost of capital in four key markets. Vodafone’s free cash flow does not cover investments and shareholder returns, although the disposals are deleveraging. Shares have fallen by more than half in the past five years.

The remedies are scarce. Della Valle promises to improve Vodafone’s performance by streamlining its headquarters and devolving power and responsibility to operating subsidiaries. The company is cutting more than 10% of its workforce. It will reinvest the savings into a better customer experience, presumably. He plans to go after higher-margin commercial clients, who appreciate his brand.

That’s reasonable, but it doesn’t amount to a strategy to replace Vodafone’s failed push for advantages of scale.

Former finance chief Della Valle deserves credit for putting Spanish assets under lockdown. She is open to other changes in the group structure. You should follow this line of reasoning. Vodafone’s market capitalization is £23 billion. That’s an almost 30% discount on the sum of Citigroup’s parts valuation.

Vodafone cannot afford to linger. The remaining investors, kept waiting for a long time, need little excuse to disconnect. The pressure for a breakup will persist and intensify.