It is difficult to admit, no matter our age, but our parents were right, even when it comes to grown-up behavior such as investing in the stock market.
How to invest?
As children, we all grew up with the story of the turtle and the hare. “Slow and steady wins the race,” our parents and teachers told us.
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It is human nature to run. We see what’s in front of us and we want to run and reach the finish line. But, as our parents advised us when we were younger, slow and steady wins the race – especially in investing.
Professors Ambrus Kecskes (Virginia Polytechnic Institute and State University), Roni Michaely (Cornell University and the Interdisciplinary Center), and Kent L. Womack (Rotman School of Management at the University of Toronto) recently wrote a paper entitled, “What Drives the Value of Analyst’ Recommendations: Earnings Estimates or Discount Rate Estimates?”
It turns out that the slow and steady approach (earnings estimate recommendations) brought in 50%-200% higher earnings than the recommendations that were discount rate-based.
Different stock recommendations
What are earnings-based and discount rate-based recommendations?
Earnings-based recommendations are recommendations based on changes in earnings estimates. An earnings estimate is an analyst’s estimate for a company’s future quarterly or annual earnings. Analysts use forecasting models, management guidance and fundamental information on the company in order to derive an estimate.
Discount rate-based recommendations are recommendations based on changes in discount rate estimates. A discount rate refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. The discount rate in DCF analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flow. These recommendations refer to undervaluation or overvaluation based on recent relative stock price changes or relative valuation ratios (eg: price-to-earnings).
Since earnings-based recommendations are more informative than discount rate-based recommendations, they yield more positive results (short and long term).
Now, let’s take the theory out of the equation and look at a real-life scenario.
On November 27th, Nuance Communications Inc. (NASDAQ:NUAN) came out with their quarterly report and yearly outlook.
TipRanks’s 3-star analyst, Brent Thill from UBS, cut his rating of Nuance Communications shares to Neutral from Buy while TipRanks half-star analyst, Ronnie Moas from Standpoint Research recommended a Buy rating and an $18 price target.
Why the difference in ratings? It comes down to approach.
Thill cut the price target from $22 to $14 due to “low conviction on growth guide for rev +5% (mid-pt) and bookings +15%.” He cited earnings-based reasoning for his downgrade to Hold. Reasoning included: “(1) broad deterioration throughout FY13; (2) highly complex pdt line & pricing model; (3) gradual & unclear pace of shift to ratable model; (4) multi-yr headwinds in healthcare SaaS transcription, smartphones, & consumer desktop software. ” He recommended the Hold because he sees promise for the company, primarily in its newer products, such as “Clintegrity” and products for mobile. He also thinks that activist investors may prompt shareholder-friendly action at the 2014 annual meeting.
A look at Nuance from analysts view point
While Thill downgraded his rating of Nuance Communications Inc. (NASDAQ:NUAN) due to the his long-term outlook of the country, Standpoint’s Ronnie Moas looked at the short term indicators, concluding that “the stock is a nice price for good company.”
Only time will tell whose recommendation reigned supreme regarding Nuance Communications Inc. (NASDAQ:NUAN), but their track records give a good indication of what’s to come. While Moas has an average return over the S&P 500 (INDEXSP:.INX) of (-)2.7%, Thill has an average return of (+)0.3%.
So, the next time you read an analyst’s recommendation, be sure to look at the recommendation itself, and not just the rating. It could mean the difference of long term economic change, rather than just a medal of who won the race.
By Uri Gruenbaum
Uri Gruenbaum is the CEO of TipRanks, a financial accountability add-on browser.