Special Report: Dancing with the Analysts

Nov 16, 2006 by

 David A. Mallach

 David A. Mallach, Sr. VP of Investments, Merrill Lynch

One of the best features of being a student at Wharton is the access it has given me to smart people. Today, I heard a presentation by David A. Mallach, Sr. VP of Investments at Merrill Lynch and author of Dancing With the Analysts. Mr. Mallach was the guest of the University of Pennsylvania’s chapter of Alpha Kappa Psi, a professional business fraternity.

At the beginning of the presentation, Mr. Mallach asserted that, in general, successful investors all have the following:

  • A game plan
  • Access to reliable information
  • The ability to exhibit a degree of patience

Mallach stressed the fact that past performance is not indicative of future results. An avid pilot, he gave the following analogy:

When you invest, all of the risk is in front of you. The historical data is useless. When flying a plane, you want to know the weather today, not the weather last Thursday. The radar points towards the front of the airplane, not the back.

Instead, he advised examining the future projections of analysts. By examining the predictions of multiple analysts, it is possible to get multiple views of the future state of the market. By tracking the accuracy of the past predictions of analysts, one can better determine their reliability. Mallach tracks the monthly predictions of analysts and tracks the corrections that they make to their predictions.

However, many times, predictions are inaccurate, as future success is sometimes unanticipated. When success cannot be anticipated, it cannot be factored into projections. For instance, Mallach mentioned that upon the release of the iPod, Steve Jobs anticipated sales of one million units. Although Jobs has more internal information about Apple than anyone else, even he could not accurately project the trajectory of iPod sales.

 Mallach then spoke of the rise of capitalism and greater market efficiency. When he began working in 1973, the volume of trading on the NYSE was only about two million transactions per day. Now, about three billion transactions per day occur on the NYSE, and there are also many transactions that now occur on the NASDAQ. Thus, the market is more efficient, as more transactions are taking place. An additional capitalist revolution is the compensation of workers with corporate shares. In the past, workers worked for kings and banks. Now, they (to some extent) work for themselves, as they share in the ownership. While this structure is prevalent in the U.S., it is less prevalent in other countries. In Germany, only about twenty stocks are actively traded, and many large businesses are privately held. The world market is in the process of moving towards the American model.

Mallach then spoke of the importance of a game plan. He stated that a analyst’s opinion is not a game plan, but that it is necessary to have data to make a plan work. He then stated:

  • 3% of success comes from knowing what to buy
  • 95% of success comes from knowing when to sell
  • 2% of success comes from knowing what to reinvest in

Unfortunately for investors, Wall Street is not in the business of telling what or when to sell. When companies start failing, research analysts often stop tracking them. He has found that such companies typically underperform the market.

Mallach was also a bit critical of diversification. He reminded the audience that all the richest people in the world have concentrated wealth. Bill Gates didn’t get rich through diversifying. Modern Portfolio Theory encourages the rotation of shares, so that mutual funds maintain a constant percentage of investment in each sector. The problem with this is that it overemphasizes selling winners automatically.

He said that picking stocks is not the issue due to efficient markets. Instead, one must focus on when to sell. Mutual funds mention in their prospectuses the conditions under which they sell. In the real world, you should let your winners run. To make money on a stock that went from $10 to $80, you must have had the patience to hold onto it when it went to $20, and then down to $15, and then up to $40, and then down to $30, and then up to $80. If you always sell when you have a 10% gain, you will never see 8x growth of an investment.

 When investing, Mallach asks himself which industry sectors are going to change the most. There are only 55 sectors, and many are quite stagnant. He cited the railroad and airline industries as industries of little likely future innovation, while stating that there is likely to be great change in the next decade within the pharmaceutical industry. He stated, instead of fighting industry change, you must “dance” with the analysts and move your projections as the analysts move.

Mallach ended the presentation by speaking about the importance of good research. He said that excellent research is correlated with excellent returns, good research is correlated with good returns, and poor research is correlated with poor returns. Unfortunately, 85% of people use no research. To perform good research, look at the raw projections of analysts. Analysts can use poetic adjectives, but the projections must reflect an honest prediction of earnings. This information, if aggregated over multiple analysts, is likely to be accurate, as the market corrects for deliberate inaccuracy. Researchers that make poor predictions over the long term are fired.

Jumping back to the irrelevance of past performance, Mallach stated, a company’s stock price stays up not because of its performance during the previous quarter, but because the expectations for its future performance have increased. Thus, one should buy a stock if analysts raise their projections of future earnings, and sell if they lower their projections of future earnings.

As a parting message, Mallach advised the audience to try to get as many stock options as possible upon being hired by a company. He felt that having ownership in one’s company is the American Dream.

 


   

So, what does this all mean for How would you invest $2,000? It may surprise you, but I founded this site in part to obtain proprietary research. As Mallach said, 85% of investors do little to no research. Nonetheless, they still invest. Their investment decisions, however wise or foolish, do impact the market. Through adopting a social approach to finance, I hope to incorporate the views of investors with varying levels of information in my predictions. Thus, yesterday’s column tried to capture the sentiment of the investing “man on the street.”

2 Comments

  1. With the emphasis on selling at the right time, rather than which stocks to pick, it sounds to me like Mallah is advocating a market timing approach to investment.

    There are those (such as Warren Buffet) who would argue that this is more speculation than investment. However I would counter that Warren Buffett himself recently did a complex merging of his company with General Re Insurance, which resulted in the effective sale of heaps of his highly priced stock and purchase of Bonds.

    But by structuring it as a merger he avoided the tax and market liquidity problems he would have met in a normal sale and purchase of many billions.

    Indeed Mallach then goes on to say that you need to select stocks based in the right sector of the market, which totally contradicts his earlier statement about only “3% of success comes from knowing what to buy”

    Lastly, I would ask just how much Mallach has made on the market, from investment success rather than from fees.

  2. Janine

    I am probably a perfect example of the “mis-educated” investor. I need information in lay terms, and tend to rely on “pop” investment advice from some of the more mainstream websites. When I read the statement “Unfortunately, 85% of people use no research. To perform good research, look at the raw projections of analysts. Analysts can use poetic adjectives, but the projections must reflect an honest prediction of earnings. This information, if aggregated over multiple analysts, is likely to be accurate, as the market corrects for deliberate inaccuracy”…. I thought… Great! But what the heck do I know about understanding raw projections and finding multiple anyalysts, no less aggregating data? The common “man”, woman in this case, needs this information in lay language. So… who is going to teach this to the masses?

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