Be on 3-1 sr, Seu Phing @ Re oT cea e gee ea Y BR Ag Vs Wy a hen Page 1 ~ ON BEING RIGHT IN SECURITY ANALYSIS Cogitator (THE ANALYSTS JOURZAL By Cog First quarter 1946 ) The most interesting and i-portant work of tho senior analyst leads up to and includes the recommendation that ve tell one sr more common atocks be purchased. How ca: whether such a reconuend¥tion as been right or wrong? This seems lixo a simple question, but a really satisfac- tory answer ts not so easy to find. “then a departaont store buyer recociends the purchase of certain merchandise, he implios that all -- or nearly all -- of 1b can be sold at tho standard mavi= nost 9 during the current season. 7 eases tho soundnoss of such rocounendations can be readily choexed by tho sequel. Jihea q stoci: warket analyst re= covmends the ouschase of stoo' ab 0, om the grounds that move r.,is imminent, it should not be too s'fficult t check the "rightness" of such its technical action Indicates an upwa a proposal. Most of us would agree that for the arzet analyst to be ovoved right th nce, say, rfot less than four points in not more than, say, 59 days. Sut if a security anlyst should recomend the purchase of United States Steel at 90, asa good buy", whit eriterta of corresponding definiteness can we apply to test his wisdom? Obviously we cannot ask that tho stoc’: so us four points in 69 days. Shall we reyuire that italvance 10% in a year? or that 1t do 10% vettor than "the general sirket"? Of that,Page 2 regardless of market action, the stock should meet certain requirements with respect to dividends and earnings, over, say, a five-year period? have no scoring syaten for security analysts, ind hence no battin; averages. Perhaps that is Just as well. Yet tt woull be anomalous indeed if we were co devote our 3 to clients without lives to aaling conerete rocommendat being able to prove, either to thea or to ourselves, whether we were right in say given case, ‘The worts of a good analyat udéowstedly shows itself decisively over the years in the gum sotal results of nis recommendations, even thouga precise eriteria Cor evaluating them be lack‘ng. Bub it is unlikely develop professional stature in that security analysis coul the absence of reasonably definite and plausible tosts of tho soundness of Individual or group rocomondations. 144 us try, tentatively, %2 foraulate such tests. tie return t suaotion that a security analyst ls now recomonding that United States Steel common be yousht at 30. If this is e@ sound recommendation, not only must it worl out hho market, but it must be based on sound reacon’ also. For without such reasoning we may have a sood market tip but we cannot havo a 700d security analysis. The rvasoning, however, may take various forms, and the meaning of the recommendation itself will vary with the reasoning venind it, Let us llluatrate by four alternatives:Page 3 1, Steel should be bought because its future earning power 1s likely to average about $13 per share (see C.J.Collin's article; THD ANALYSTS JOURNAL, July 1945, p 23). “2, Steel should be bought because it is fundamentally choages at 80 than ie the Dow-Jones Industrial Average at 190. 3. Steel shouta be bought at 80 because next year's earnings will show a substantial incroase. h, Steel should ve bought at 52 because that price is far below the top figurz reached in the last two bull markets. Reason 1 implies that Stecl will orove a satisfactory longs pull investuent. ‘That does not mean necessarily that it will average eaminys of *13 over the next twenty-five yoars, but certainly over the next five years. If this analysis >roves correct, the surchaser will have both satisfactory earnings and dividends and an undoubted opgortunity to sell out ata good advance. Tas correctness of ths sialyats and the con- goquent recommendation can oe proved only over a five-year oeried or Longer. Suppose that the same suzgostion, with similar reasoning, on Steel was also selling at had been made in January 29375 80? ‘Yiould thas analysis have deen right? Nos even though the stocr proastly advance 57% to 124, For in no flve-year pe Lod since 1934 have the earninzs averaged &7 er share, and the 1937+!) avoraze was about “S per shara, The rise to 126 within sixty Jays did not estadlish the richtness of thisPage analysis, any more than the decline to 35 in the following ‘twelve months would necessarily have proved it to'™ wrong. The recom sondation to buy United States Steel because it Is cheaper than the Jow-Jones Industrial Average (reason 2) would represent a valid and standard fors of analytical arsue ment. It may or may not be cousled with the statement that Steel is attractive in tte om right. In the former case, it would be equal to recommendation 1, alus the assortion that Steel is cheaper than other standard issuos, But the analyst svonorly may recommend Steel common on a comparative basis only, without claiming that Ib ts intrinsically cheap, In that case he will ve proved right 1f “teel serforas better than the average, even though Lt say not do well by itself. For oxauple, if Steol declines to 70 within a year from now, woile the 2ow-Jones Industrials decline ts 10, the comparative recomaendation should be called right - provided (a) it was na (b) 1¢ was backed originally couchod in comparative terns, by plausible anulytical reasoning. Proviso (o) would seem necessary in every case where a sin;le recownendation is test- ed, in order to mito sure that the rightness is not/ooviously to mero Luck Recommendations to buy a stocs for the main reason that aro going to ve higher (reason 3) are next year's carat among the most comson in ‘tall Street, They have the advantage boing subject to rathor simsle tests, Suci a rocommendati.n will be right if both (i) the earnings incroass and (b) thePage 5 price advances - say, at least 10% - within the noxt twelve months. The objection to this type of recommendation is a practical one. It is naive to bellave that in the typical case the market is unavare $f the propects for improved earings next year. If this is 80, the favorable factor is likely to be @iscounted, and tho batting average of recomendations based on this simple approach can scarcely be very impressive, Steel snould be bought at 80 because it sold considerably higher in tho last two bull markets (reason }), Is this a valid type of reasoning for security analysis? Opinions may diffor on this soft, but in any case wo can readly tell if suc a roco-rsendation proves right, The stock must advance substantially - say, 20% at least - in the current bull market. CONTIN TINS The preceding discussion leads to some yeneral conclusions, which are put forward on a tentative basis and as a starting point for controvery? (a) In ost cases the rightness of an anlyst's recommendation can be tested by the sequel, provided he Indicates the type and basis of his recommendation, (o) Different types of rocomieniation - even though they all may call for tha same action; for example, to buy Steel at 30 - will be tosted for richtness in different ways. (c) “whore a rocommeidation is rade on a group basis, only thePage 6 group result should be tested, Individual issues may be expected to go counter to the group trend. (4) Profossional standards for security analysis require that 211 recommendations indicate clearly both the tyve of recommendation made and the kind of analytical reasoning on which it is based. Analysts recommend bonds and preferred issues as well as common stocks. The warranty behind each such suggestion ts tha the issue has quality at least comensurate to tho yleld. Such recommendations may bo tested two ways: oither by the roview of the malysis of quality, or by sho subsequent markxot action of the issues aporoved, oroferably as compared with a 8 able grou, Index. This field of activity doos not raise sorloss probleus of, testing, oxsopt whore very refined results are roquired. Agsuming we can test the analyst's performance on in- dividual recommendations, wo can develop a crude batting aver- age for his work, based solely on the percentage of times he is right out of total number of recomendations made. How high siould this averaze be for 2 good analyst? And ts it necessary to refine this test by distinguishing between "very right" or "very wrong" and Just " rightish" or “wrongish"? These ave questions for othera to answor.