They are having to work twice as hard to keep models up to date
27/07/2022
These are tough times for everyone, especially for those who make a living out of foreseeing the future. Investment analysts, who specialize in predicting how much a stock will cost and recommending or not its purchase, are having to work twice as hard to keep their models up to date in a game that is key for them to move before the market does.
In recent months, dramatic changes in the global economic environment, with all-time high levels of inflation and interest rates, have forced analysts to revise their projections for stocks. Last week, the European Central Bank adjusted rates for the first time since 2011, for instance. Here in Brazil, a survey carried out by Valor shows that in some industries more sensitive to price increases, there has been an 80% reduction in the target prices of companies covered by banks and asset management companies over the last three months.
As reports to clients show, analysts are rushing to update “macroeconomic assumptions” –inflation, interest rates, and higher cost of capital – which invariably changes the central mechanism in calculating a company’s value: the discount rate.
To determine the “fair price” of a company, typically for a 12-month term, analysts project its cash flow for the next few years and then bring it to present value using a discount rate, which tries to balance the expected return with the risks involved.
“The discount rate is the more artistic side of company analysis and asset management,” writes asset manager Alexandre Póvoa in the book “Valuation — Como precificar ações” (“Valuation – How to price stocks”). It is an art that involves “variables that interact with each other,” for which there is no “scientifically correct answer.”
The performance of companies – one of the most important variables – seems to resist well the macroeconomic instability, which is a great unknown at the moment. One example is the constant adjustments economists are making in their GDP growth projections: they went to 2% in the most recent round of revisions from zero at the beginning of the year. The very polarized election in October is not much of a help as analysts struggle to find fair prices compared with current prices.
Recent signs of cooling inflation in Brazil, which came in the mid-month inflation index IPCA-15 data released Tuesday, may force a fine adjustment upwards – the index is known as a reliable predictor for official inflation. If the global outlook worsens even more, another round of target price cuts may come, but this time because of another variable, which is profit growth potential.
This is because regardless of companies having “their homework done,” as analysts like to say, it is very difficult for them to have a surprising growth when everything is going badly abroad.
The survey conducted by Valor with reports from 16 banks and asset management companies that cover several industries shows that the three basic categories of recommendations – buy, sell and hold – have changed little since the beginning of the year, with a strong preponderance of buys. According to the analysis, 72% of 634 recommendations were buy, 25% hold, and 3% sell. In March, the ratio was 71%, 25% and 4%, respectively.
Yet, prices changed dramatically. Sectors linked to the so-called cyclical consumption are among the hardest hit by the general course correction. In retail, which includes large chains such as Americanas, Magazine Luiza and Via, the price target reduction reached 80% of the covered stocks. In segments with better performance, such as oil, upward adjustments predominate, albeit in a more modest proportion.
“Some industries are more resilient, more protected against inflation,” says Antonio Junqueira, head of Latin America research at Citi. “In industries like electricity, for example, it happened less [price target changes] because many companies are natural monopolists, which operate under regulations that define how much money they make. Lights are on in your house regardless of whether GDP grows 2% or falls 2%,” he says.
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Gabriela Joubert — Foto: Divulgação
The reduction of a price target is not decided overnight. This work usually takes up to three weeks, says Gabriela Joubert, head of research at Inter, a Brazilian digital bank now traded on the Nasdaq. “An analysis of a large exporting company, for example, includes many variables. You have to get data, talk to the company, check information with clients, the network of contacts, distributors, and people in China, and only then change spreadsheets, update numbers, and write a report.”
Inter typically revises models once every six months, but the interval has been reduced to three months. “The macro team is revisiting its estimates more frequently, and as this happens, we need to change our models as well,” Ms. Joubert says.
In calmer times, analysts can push the macro scenario to the back burner and focus on companies and sectors, says Fernando Ferreira, the chief strategist of XP. Amid a turmoil, the work includes following closely and try to measure the impact of any news related to the zero covid policy in China or the signals from European central banks. “The staff ends up working a lot more,” Mr. Ferreira says.
Customer service work has also increased. “We started to hold more live-streaming talks and meetings with the commercial team to try and calm things down a bit,” says Ms. Joubert, with Inter.
“Many investors don’t understand why there are so many changes, so we explain the change in fundamentals,” says Mr. Ferreira, with XP. “Analysts don’t have a crystal ball. They update their assessments according to what is happening.”
The big challenge for the sell side – bank analysts who make recommendations to clients, while the buy side are the managers who manage portfolios – is to be able to change target prices before the stock market in general. “Sometimes this is very difficult, because the market usually moves first,” says Mr. Póvoa, who has worked in both sides and currently is head of analysis at Meta Asset. Besides this, changes must be approved by other departments, such as compliance, which makes the work a little slower than on the buy side.
Regardless of the side, what matters in times of high volatility such as this one is that analysts manage to keep a cool head. “It is very important not to get too excited during the good times of the cycle and not too depressed during the bad times,” says Mr. Junqueira.
*By Nelson Niero, Rita Azevedo — São Paulo
Source: Valor International