Why analysts' forecasts are off target
The trouble with stock-market analysts is not that they try to forecast a company's earnings, then put a price on the stock. The trouble is they stink at forecasting earnings. What they should do is compare a stock's price with investors' expectations about the stock.
That's the view of Greg Forsythe, senior vice president of Schwab Equity Ratings, an arm of Charles Schwab that has won praise for its awesomely high returns.
Analysts' forecasts at the beginning of a year, according to Forsythe, differ by an average of 40 percent from actual reported earnings for that year. And there's zero correlation between their forecasts for five-year earnings growth and the actual growth of earnings for the next five-year period.
Someone who bought and held an index of stocks from 1991 to 2006, he added, would have gained 14 percent a year. Whereas the 20 percent of stocks with the highest earnings forecasts of earnings growth - supposedly the very best choices of the analysts - would have earned a mere 9.7 percent a year.
The trouble is that analysts pay little attention to valuations, Forsythe said. Just because a company is "great" or "a leader" doesn't mean investors can make money buying the stock. "Research based on earnings has been misplaced," he argues. Instead, research should focus on possible surprises - the difference between expectations and likely outcomes.
Most expectations are too optimistic, he said, and the way to make a profit is to focus on stocks with low expectations - especially because it takes a while for good news to bump up forecasts. "People change their minds reluctantly. Expectations lag reality."
Haven't equity ratings begun to deteriorate?
Forsythe's answer: No, the Schwab ratings seldom are the outright winners over short periods. But they tend to consistently do slightly better than average over short periods, and it is over long periods that they race ahead.
Over five years, as of Dec. 31, Schwab was comfortably ensconced in first place among 10 brokers that issue model portfolios, with a gain of 97.05 percent. Far behind, in second place: Credit Suisse, with 57.06 percent. (Data from Zacks Investment Research, as reported in Barron's.)
Over three years, Schwab was in third place, with 52.48 percent, slightly behind Smith Barney Citigroup, but far behind Morgan Keegan, with 83.71 percent. Over one year, Schwab was in seventh place, with 13.67 percent, far behind Matrix USA, with 28.94 percent. Over six months, Schwab was in eighth place, with 9.08 percent, far behind Matrix USA's 18.44 percent. (Bottom performer in all time periods: Raymond James.)
Schwab offers a ton of mutual funds - which not long ago seemed to be a secret even to Schwab employees, said Evelyn Dilsaver, president and CEO of Charles Schwab Investment Management. The 73 Schwab funds have over $200 billion in assets, and more than 65 percent of them get four- or five-star ratings from Morningstar. Add the sister Laudus funds, and 55 percent still receive four or five stars. Only 31 percent of Fidelity's funds receive four or five stars.
Talking about Schwab's new index funds, based on Bob Arnott's criteria, Katrina F. Sherrard said that the Achilles' heel of capitalization-weighted indexes is that they contain overvalued stocks. (Cap weighted: stock price times number of shares out there.) Because of a cap-weighted index's Achilles' heel, she said, it has a yearly 2 to 3 percent drag on performance. The Arnott RAFI indexes focus on price to book ratio, book value, price to sales and dividends. "They break the link," she said, between an index and overpriced stocks.
Most actively managed funds, she added, don't outperform index funds.
Won't index funds spell the death of actively managed funds?
Replied Dilsaver, "No. How well your index funds have done doesn't make good cocktail party talk. Besides, it's human nature to believe that you can do better than an index fund. Active investing will always be dominant."
On the subject of exchange-traded funds, she said that while there are 500 such funds, most people simply invest in ETFs of the major market indexes, Qubes (the Nasdaq 100) and SPDRs (the Standard & Poor's 500). So, she concluded, they won't steal shares away from individual securities.
Kim Daifotis, in charge of fixed income, said a tug of war is going on between advocates of fighting inflation, who want the Federal Reserve Board to raise interest rates, and advocates of rate reductions, to help the economy. His predictions: the Fed won't lower rates until the first quarter of next year, and bonds will return 5 or 6 percent this year.
He suggested that investors avoid high-yield bonds and concentrate on high-rated bonds. (Schwab YieldPlus Investor, which Daifotis runs, is a five-star fund.)
The Schwab Global Real Estate Fund, said Jim Sempere, focuses on commercial real estate, not residential. It covers 400 companies in 250 markets - 48 percent in North America, 27 percent in Asia, 25 percent in Europe. One of the fund's strengths: low correlation with the Standard & Poor's 500 Stock Index. The minimum first investment is low: "One hundred bucks and it's yours."
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