Rudi's View | Jun 25 2020
Dear time-poor investor: stockbroker price targets can be a handy tool for investors, when treated with intelligence and experience
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Price Targets Can Be Your Friend
By Rudi Filapek-Vandyck, Editor FNArena
I haven’t written about stockbroker price targets and consensus targets for a while, plus I received a number of questions about them recently. Time for an update.
Let’s assume I like a certain company and I would like to buy its shares and add to my investment portfolio.
I might have an idea about what this company does, and how it’s positioned in an overall groovy looking industry.
There is a past record to pay attention to, and forecasts are available too. I might even look at a price chart to see how the share price has performed and how volatile it is.
But how much do I think the shares are worth?
It’s an intriguing question and one that can potentially elicit endless discussions about Ben Graham’s base principles and how much of an influence low inflation and bond yields near historical lows exert on a company’s valuation in modern times.
There is also the added observation that an extremely low valuation is seldom an indication of a low risk, sustainable longer-term investment while an above-average Price-Earnings (PE) ratio is not necessarily a harbinger of a share price crash that hasn’t yet happened.
In reality, many of the stocks trading on higher PE ratios have proven a much better investment than peers on low PEs, and this has been going on for many years now.
So why don’t I leave this to the experts who are paid to follow and analyse stocks as a full-time occupation?
Most stockbroking analysts these days are kind enough to not only calculate a valuation based on their modeling assumptions and forecasts; in most cases they provide a price target too – it’s where they think the share price should be in 6-12 months’ time, all else remaining equal.
Those four words at the end of that previous sentence give away the first and foremost mistake many investors make when focusing on stockbrokers’ price targets. Theirs is not a static process, such as determining the distance between Brisbane and Melbourne.
In the share market, as well as in the real world (i.e. the day-to-day economy), circumstances and context remain seldom the same for very long. This clashes with our human desire to receive guidance that is set in stone, irrespective of what happens.
It’s the same error investors make when basing decisions on PE ratios. Years ago, it was pointed out to me High PE stocks such as REA Group ((REA)) and Seek ((SEK)) usually saw their shares weaken around May-June each year.
Because that’s when PE ratios elevate beyond historical averages. That is, if we continue to focus on the financial year that is about to end and which will be reported in August.
The crucial error investors selling out were making is that professional investors by now are already looking forward to FY21 and FY22.
Sure, we don’t know yet what the exact numbers in August might look like, but if these growth companies continue to grow year after year, then this year’s PE ratio has to look high by the time the calendar shows May-June.
It’s either that or something’s wrong with how fast these companies are growing.
Lesson number one is thus: financial indicators, whether they be targets or forecasts or a multiple derived from forecasts should never be treated as an inflexible, stand-alone, set-in-stone, never-to-change indicator.
Always keep in mind things can, and will, change.
This in particular applies for sectors and stocks that are impacted by many moving inputs, like commodity producers.
Another complication is that when multiple experts look at the same company, they often end up drawing different conclusions.
UBS doesn’t like Afterpay ((APT)). The broker currently has a price target of $14. At Ord Minnett the price target was recently raised to $64.70.
No guessing why UBS has a Sell rating on the stock, and Ord Minnett has a Buy.
Most analysts covering Afterpay have a price target closer to Ord Minnett’s, but most are below today’s share price.
So what’s the ordinary investor to do with so much conflicting inputs?
Enter consensus price targets. Many years ago, I discovered consensus price targets, essentially the average of multiple targets published by stockbrokers covering the same company, can be used as a handy tool for assessing entry and exit decisions.
As a rough, plain vanilla concept, my interest is usually awoken when a share price weakens more than -10% below its consensus target.
Every time I try to establish what is likely the cause of this gap opening up. There is a big difference between market momentum switching out of, say, Coles ((COL)) and Woolworths ((WOW)) as a result of portfolio rotation by institutions into banks and commodity stocks and, say, Speedcast International issuing yet another profit warning, which forces management to renegotiate the company’s survival with its lenders.
When things change, one has to remain flexible enough to accept that things have really changed, and not necessarily for the better.