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10 'predicted surprises' from best-bet analysts
StarMine rates the likelihood that a stock's price will reflect its earnings expectations, in part by giving more credence to analysts with the best records. It's a useful tool for ranking experts, but how about stocks?
By Jon D. Markman
Ninety-nine percent of brokerage analysts are giving the rest a bad reputation. Yet you have to wonder whether that last 1% actually might provide something of value to investors.
During the great bull run of the late 1990s, a handful of companies staffed with both math whizzes and washouts sprang up like dandelions with plans to rate analysts. Most were rank amateurs at both business and analysis and disappeared in million-dollar clouds of dust.
But one of the few left standing offers some real insights into this opaque and sometimes-crooked profession. That would be StarMine, a company that started out in 1998 with a weak and incomplete system for analyst analysis. But the company has steadily improved to the point that some brokers are hiring it to measure their own stock-picking effectiveness.
The need for such heuristics becomes evident on a day such as Friday -- a day that contained news of the tentative federal approval of a new psoriasis drug from battered biotech titan Biogen (BGEN, news, msgs). It didnt take long for every pharmaceutical analyst in the land to scratch a note on the meaning of the announcement, and opinions ranged from a startling Sell/Reduce from Merrill Lynch to the reiteration of a strong buy from A.G. Edwards.
They cant all be right, of course. As they say in the industry, on average, all analysts are average. But at the same time, its possible that one or two specialists in any given large-cap stock might consistently get it right -- either in their estimates of future quarters earnings, or in their timing for upgrades and downgrades, or both.
Anticipating the anticipators
The StarMine thesis starts with the well-documented fact that one of the few quantifiable events predicting future stock-price movements is analysts earnings-estimate revisions. The company believes its possible to go one step further, however, and attempt to predict which companies will be the subject of rising estimates in the future. Essentially, that puts StarMine in the business of anticipating the anticipators, which is even harder than it sounds.
Founder and Chief Executive Joe Gatto -- who started his career as a decision-engineering consultant after graduating from Stanford University-- says that until 2000, it was possible to predict revisions by examining past revisions: Changes in analyst estimates over the past 30 days had a strong, persistent correlation to changes over the following 30 days. But the Securities and Exchange Commission changed all that when it promulgated Regulation FD, prohibiting companies from selectively informing favored analysts or investors about their business prospects before others.
Analyst revisions had worked as a strategy because there was a delay in the diffusion of information. Company A would tell Analyst B (whose firm had helped with its stock underwriting) that it was selling more widgets than expected in the quarter. Analyst B would tell Fund Manager C that he was planning to raise his earnings estimates on the stock, expecting that the tip would encourage the fund manager to buy, say, 100,000 shares of the stock through his brokerage (a percentage of the commissions on the trade would be credited to the analyst). After buying his fill, Fund Manager C might leak the idea to Reporter D, sagely opining that the company would beat its numbers. Reporter D might then continue the contagion by calling Analyst E for confirmation of the idea. All the while, as the original data bit -- the analysts upward earnings revision -- diffused through the investment ecosystem, the stock would rise. Of course, it was the Retail Investor who got an F for ultimately buying the stock on the companys actual rosy earnings report, because Players A through E by that time were taking profits --and sending the stock down.
Regulation FD, for all its many faults, was intended to stop this madness, which resulted in a predictable chain-letter change in consensus as analysts successively attempted to stay in line with their peers so they didnt look stupid. Now when a company publicly declares on a conference call that business is better, all analysts change their estimates from, say, $1 per share to $1.10 at once. The new information is then immediately reflected in the market.
It took a while for guess-guessers such as StarMine to figure out what to do about this change, but ultimately it has made the game of expectation-expecting more complex. StarMine calculates a smart estimate for a stock by overweighting the most accurate analysts estimates and dynamically throwing out old estimates as they age. It then compares the smart estimate to the consensus estimate and uses the oxymoron predicted surprise to describe their divergence. In other words, if the consensus estimate for a quarter is $1 per share, and the smart estimate is $1.10, the predicted surprise is 10%. Gatto says that historical testing in all market cap groups, sectors, styles and countries (except, curiously, Slovenia), shows that when the difference is 10% or more, the stock does surprise in the predicted direction 75% of the time. StarMine then combines that figure with a handful of other factors to create a StarMine Indicator, a rating of 1 to 5, with 1 being best, to summarize a stocks prospects for positive surprises and higher prices over the next one to six months..
How it all works, or doesnt
All of that sounds pretty good, but the indicator seems to have failed the Biogen test on Friday.
First the good news:
- A visit to StarMines professional-level Web site shows that it identified the team of Craig West and Alex Hittle at A.G. Edwards as tops among 16 analysts on Biogen stock, giving the duo a rare five-star rating for accuracy and putting 9.9% of the weight of the smart estimate on their shoulders (a normal weighting would be 1/16, or 6.3%).
- StarMine identified David H. Williams, of Fulcrum Global Partners, as the least capable analyst on the stock, 16 of 16, with a 1-star accuracy rating and a 3.3% weighting.
- The divergence was prophetic because Fulcrum issued a report on April 1 predicting that the Food and Drug Administrations Advisory Committee would not recommend approval of Biogens psoriasis drug Amevive, and rated the stock a Sell. In contrast, West-Hittle of A.G. Edwards wrote on April 21 that they liked the risk/reward of betting on approval of Amevive and rated the stock a Strong Buy.
- On May 23, the FDA panel voted 10-2 in favor of approving Amevive, and Biogen stock shot up 22%, its best one-day move in five years.
The bad news? The StarMine Indicator for Biogen going into Friday was a very negative 5 -- probably because the drift in earnings revisions going into the big day was on the decline.
But one day and rating does not an analytical system make, so I will withhold judgment and watch the 10 stocks shown in the table below over the next 3 months. The first five (all from a strong industry, energy) have the largest predicted positive surprises through May 27. All are StarMine 1s. The next five (all from a weak industry, software) have the largest predicted negative surprises. All are StarMine 5s.
| 5 StarMine longs | | Sym. | Smart Estimate | Consensus | Predicted Surprise | | Noble Affiliates | NBL | $0.04 | ($0.03) | 66.70% | | Devon Energy | DVN | $0.99 | $0.81 | 22.50% | | Key Production | KP | $0.33 | $0.28 | 18.90% | | Penn Virginia | PVA | $0.12 | $0.11 | 9.90% | | Remington Oil & Gas | ROIL | $0.12 | $0.11 | 8.60% |
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| 5 StarMine shorts | | Sym. | Smart Estimate | Consensus | Predicted Surprise | | SilverStream Software | SSSW | ($0.36) | ($0.32) | -14.0% | | JD Edwards & Co. | JDEC | $0.06 | $0.06 | -3.9% | | Agile Software | AGIL | ($0.21) | ($0.20) | -2.5% | | MRO Software | MROI | $0.02 | $0.03 | -2.3% | | Legato Systems | LGTO | ($0.05) | ($0.05) | -2.0% |
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U.S. Bancorp Piper Jaffray, Merrill Lynch, W. R. Hambrecht and three other sell-side brokerage firms arent waiting for more evidence, however. They have asked StarMine to rate their analysts privately so their research director can keep track of capabilities. You would think that, after all this time, the firms already had this capacity in house. But it turns out that the brokerages have much more elaborate systems for tracking how many phone calls the analysts make to clients pitching their research than they do for tracking whether the research makes sense. Gatto also claims to have 80 buy-side clients paying $15,000 to $80,000 per year for his companys richest set of professional-grade analytical tools and factors.
The smart-estimate and predictive-surprise concepts make sense, and they should offer both consumers and pros a way of finding that top 1% of analysts in any sector or stock whose real value is overshadowed by the mediocrity and mendacity of the rest. But I would use them as one or two tools among many, since a clear lesson of the bear market has been that there are no single magic bullets, holy grails -- or lucky stars -- when it comes to the serious, difficult task of investing.
Fine Print
To learn more about StarMine, visit its free retail Web site. You can get predicted surprises -- but not ratings -- on about 3,000 stocks. The professional-grade site is here. It has the indicators, plus drill-down lists of the best and worst analysts for each stock. . . Youve got to give Gatto credit for being a financial services dot-com survivor. The one-minute bio: Gatto grew up in the industrial part of Westchester County in New York, where he said he used to caddy for the rich kids at the Scarsdale Golf Course. His father was a life insurance salesman who liked to bet on the ponies and football games . . . Gatto said he looks at StarMine as akin to a card-counting system for blackjack, helping investors get an edge on the house by putting the odds in their favor He studied electrical engineering at Catholic University in Washington D.C. on a scholarship, then got a job doing Hunt for Red October-type submarine warfare programming at the U.S. Naval Research Laboratory before going on to Stanford. . . In 1991, he went to work at Strategic Decisions Group in Menlo Park, Calif., where he helped to model billion-dollar decisions for Fortune 100 pharmaceutical and energy companies. One example: An oil company drilling in a remote corner of a foreign country needed to decide what to do with the huge volume of natural gas that flared off its oil rigs. Possibilities were: Let it go into the atmosphere, where it would be an environmental hazard; capture it and send it to the West as liquefied natural gas, necessitating expenditure of up to $2 billion on an LNG facility and pipeline; or spend $100 million on an experimental system of pumping it back into the earth. These kinds of decisions were similar to what StarMine does: Helping companies do probability analysis on uncertain outcomes. You couldnt get McKinsey to come in and do a marketing study for you on this sort of thing. You had to embrace the future and quantify the scenarios in a Bayesian framework, he said. To learn more about Bayesian analysis, visit this Web site. . . . Final fact: Gatto estimates that the average portfolio manager gets 600 e-mails and research reports a day. Overall, he estimates there are 2,500 new or revised earnings estimates daily, or 65,000 per year. . . . Following are the top 50 StockScouter and 10 HiMARQ stocks for June:
| StockScouter Top 50 -- June 2002 | | Name | Sym. | Rating | 5/31/02 Close | | American Capital Strategies | ACAS | 10 | $29.95 | | Annaly Mortgage Management | NLY | 10 | $19.60 | | Apex Mortgage Capital | AXM | 10 | $14.43 | | Cathay Bancorp | CATY | 10 | $42.58 | | Charter One Financial | CF | 10 | $36.20 | | Citizens Holding | CIZ | 10 | $14.95 | | Countrywide Credit Industries | CCR | 10 | $49.31 | | Deltic Timber | DEL | 10 | $32.05 | | Energizer Holdings | ENR | 10 | $26.95 | | First BanCorp | FBP | 10 | $35.61 | | First Keystone Financial | FKFS | 10 | $16.58 | | Firstbank | FBMI | 10 | $23.88 | | FirstFed Financial | FED | 10 | $29.50 | | Franklin Bank, N. A. | FSVB | 10 | $19.35 | | Golden State Bancorp Inc. | GSB | 10 | $38.21 | | Hudson United Bancorp | HU | 10 | $30.80 | | Nationwide Financial Services | NFS | 10 | $43.15 | | New Hampshire Thrift | NHTB | 10 | $18.51 | | Northeast Indiana Bancorp | NEIB | 10 | $15.67 | | PMI Group | PMI | 10 | $85.60 | | Provident Energy TR UTS | PVX | 10 | $7.18 | | RAIT Investment Trust | RAS | 10 | $21.91 | | Renal Care Group | RCI | 10 | $33.71 | | Teva Pharmaceutical Ind | TEVA | 10 | $67.03 | | UCBH Holdings | UCBH | 10 | $39.48 | | UnionBanCal | UB | 10 | $49.04 | | Winton Financial | WFI | 10 | $9.98 | | Wintrust Financial | WTFC | 10 | $28.86 | | Advisory Board | ABCO | 10 | $36.30 | | BG Group plc | BRG | 10 | $22.15 | | BankUnited Financial | BKUNA | 10 | $17.85 | | Big Lots | BLI | 10 | $17.90 | | C&F Financial | CFFI | 10 | $23.50 | | CBRL Group | CBRL | 10 | $33.25 | | Central Parking | CPC | 10 | $24.60 | | Coastal Financial | CFCP | 10 | $13.80 | | Columbia Bancorp | CBBO | 10 | $12.40 | | Comp De Minas Buenaventura | BVN | 10 | $29.85 | | Edison International | EIX | 10 | $18.66 | | Encore Acquisition | EAC | 10 | $15.49 | | Fidelity National | LION | 10 | $10.60 | | First Niagara Financial Group | FNFG | 10 | $25.36 | | Fomento Econmico Mexicano | FMX | 10 | $42.25 | | Greater Bay Bancorp | GBBK | 10 | $32.89 | | Harbor Florida Bancshares | HARB | 10 | $22.75 | | Harrah's Entertainment | HET | 10 | $47.65 | | Hilb, Rogal and Hamilton | HRH | 10 | $41.21 | | Investors Title | ITIC | 10 | $20.01 | | Investors Financial Services | IFIN | 10 | $77.26 | | Kinder Morgan Energy | KMP | 10 | $34.02 |
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| StockScouter 10 -- SC | | Name | Sym. | Rating | Sector | 5/31 Close | | American Capital Strategies | ACAS | 10 | Financial | $29.95 | | Annaly Mortgage Management | NLY | 10 | Financial | $19.60 | | Deltic Timber | DEL | 10 | Basic Industries | $32.05 | | Energizer Holdings | ENR | 10 | Consumer Non-Durables | $26.95 | | Renal Care Group | RCI | 10 | Health Care | $33.71 | | Teva Pharmaceutical Ind | TEVA | 10 | Health Care | $67.03 | | Fomento Econmico Mexicano | FMX | 10 | Basic Industries | $42.25 | | Harrah's Entertainment | HET | 10 | Consumer Services | $47.65 | | M/I Schottenstein Homes | MHO | 10 | Consumer Durables | $64.05 | | TJX Companies | TJX | 10 | Consumer Services | $21.09 |
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| HiMARQ | | Company Name | Sym. | 5/31 Close | | Shorts | | | | ABIOMED, Inc. | ABMD | $7.40 | | Presstek, Inc. | PRST | $6.59 | | Trendwest Resorts, Inc. | TWRI | $23.68 | | Midas, Inc. | MDS | $13.48 | | Longs | | | | Oracle Corporation | ORCL | $7.92 | | Sinclair Broadcast Group, Inc. | SBGI | $14.82 | | Wild Oats Markets, Inc. | OATS | $14.66 | | Aftermarket Technology Corp. | ATAC | $23.72 | | Endocare, Inc. | ENDO | $14.65 |
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