Four Ways to Improve Wall Street Analysis

The community of Wall Street analysts is in disarray. I can't recall a time when analysts -- many of whom are smart, talented and well intentioned -- were viewed with such disdain. Unfortunately, the disdain is often deserved. Consider the recent action of a Warburg analyst: He affirmed his per-share earnings projections for Tyco (TYC - commentary - Cramer's Take) of $2.60 for 2002 and $2.95 for 2003.

Related Stories

How to Avoid Turnaround Blunders, Part 1

The operative psychological term here is called anchoring, which means refusing to revise an opinion in the face of new information. There's plenty of "new information," of course, that would justify this analyst to revise his opinion. Just one fact alone -- that Tyco debt has been downgraded to junk, meaning its interest expense burden will rise substantially in the next couple of years -- makes the need for a change to earnings estimates obvious.

How can Wall Street analysts get better? Can they reverse the steady erosion of respect that's happened in the past few years?

If I had the ear of analysts, I'd have plenty to say on how to improve. Here are four things I'd tell them:

1. Enough of the linear projections.

Analysts currently project long-term earnings growth of 18% annually at Home Depot (HD - commentary - Cramer's Take). It's not going to happen. Combine a saturated market, cannibalization of existing stores by new stores, significant competition from Lowe's (LOW - commentary - Cramer's Take), peak margins and a lack of success internationally, and the ingredients are firmly in place for struggles ahead.

The very stuff of business is cyclical. Extrapolating earnings gains into the distant future in a straight line is nonsense and of no utility to investors. In late 2000, I said that there are only two kinds of companies: those that have problems, and those that are going to have problems. There's no such thing as a company that grows 35% per year permanently. So I'm not going to pay 35 times earnings for a 35% grower, only to be the patsy holding the stock when the inevitable problems occur.

2. Read the balance sheet.

Pick up a few analyst reports and you'll see the same thing: earnings, earnings, earnings. There's a lot more to a business than its stream of earnings. I've yet to see a decent analyst report on Tyco's balance sheet. Back in November, I said, "To the extent you can find a reasonable margin of safety supporting the stock of Tyco -- and I certainly can't -- you aren't going to find it in the balance sheet."

The balance sheet is a critical component in the assessment of risk. Analysts shouldn't begin and end their work with this year's and next year's earnings-per-share projection.

3. Anticipate!

Investors are assisted by analysts when the analysis is anticipatory. If you wait for a company to turn around before upgrading the stock, the stock price will have already adjusted. When I made many of my better picks for RealMoney, such as Office Depot (ODP - commentary - Cramer's Take), J.C. Penney (JCP - commentary - Cramer's Take), Hasbro (HAS - commentary - Cramer's Take) and Manpower (MAN - commentary - Cramer's Take), conditions at each company were awful. Waiting to upgrade or downgrade a stock after the fact doesn't create any value.

4. Take a stand against corporate excess.

We are enduring a hangover of executive excess from the last cycle. Then, you could hide 5% to 8% dilution to shareholders with growth in the underlying business and a rise in stock value. Not anymore. Not in a difficult cycle when nominal positive returns are hard to come by.

Wall Street analysts don't have to act surprised by the excess. They seem like they're the last to know (they aren't) when their heroes turn out to be lavish spenders of shareholder capital or worse, e.g., Bernie Ebbers of WorldCom (WCOM - commentary - Cramer's Take), Gary Winnick of Global Crossing, Joseph Nacchio of Qwest (Q - commentary - Cramer's Take) or Dennis Kozlowski of Tyco.

Investors could use an analyst or two who will take a stand in the face of wrong. Here's one missed opportunity: IBM (IBM - commentary - Cramer's Take) inserted gains above the line, hidden in the sales, general and administrative expense line. Any one of dozens of Wall Street analysts could've drawn a line in the sand. It's inappropriate, period.

---

This market is tough enough without having enough weapons in your arsenal. Give a subscription to my Turnaround Report newsletter a try. Click here for a free trial.

---

Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor specializing in turnaround situations. At time of publication, Alsin and/or ACM was long Office Depot, J.C. Penney, Hasbro and Manpower, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, The Turnaround Report.