APART from badminton, I believe diving is the most exciting Olympic sporting event for most Malaysians. Probably, this has to do with the fact that Malaysian athletes have traditionally done very well in both events, with the best result being a silver medal back in Rio Olympics 2016.
Naturally, our people are hopeful that either one of the events would eventually deliver the elusive gold medal for our nation.
As I followed anxiously for Nur Dhabitah Sabri, Cheong Jun Hoong and Pandalela Rinong to challenge the diving powerhouse China for a podium finish, I couldn’t help but notice the interesting scoring system in the individual diving event.
It essentially works like this: From a panel of seven judges, the top two scores and bottom two scores are discarded; the remaining three scores are added together and multiplied by the dive’s difficulty rating to reach a final score.
I find this fascinating because the methodology appears to rely on consensus to arrive at a fair assessment by negating extremities on both ends. In short, it hopes that via median scores and a consensus-driven approach, subjectivity would be eliminated when judging divers’ performance. This inevitably reminds me of how research analysts rate companies listed on the stock market.
There are many research houses in the market, so it is likely that good companies are covered by more than one analyst. This is why a concept called “consensus” becomes important. What this means is that when a listed company reports earnings, investors will assess if the company beats “consensus” or underperforms it. If the company beats “consensus” forecasted by analysts, then the share price would tend to go up and vice versa.
CLICK TO ENLARGE
This is not a hard and fast rule but it is a benchmark. With this benchmark, investors can then gauge the forecast target price against the current stock price and decide if it is viable for investment.
The idea of “consensus” is somewhat similar to diving’s scoring system, except there is no discarding of extremities at both ends. Investors can decide which report to rely on based on what makes most sense to them.
Alternatively, they can fall back on the consensus. After all, it is unlikely that a majority of analysts are wrong on a particular sector or company right? Now, what if I tell you that “consensus” may not always be based on objectivity but rather on “herd mentality” of peers? Would this “consensus” concept then be flawed?
In this regard, I would like to highlight two sectors in the stock market that come to mind. First, the tech sector after 17 months of rallying from market lows in March 2020, remains popular with investors. Looking at earnings, there is definitely a sign of healthy growth for companies within the sector.
However, if you look closer, the share price ascend predominantly comes from valuation expansion rather than earnings. What this means is that companies in the tech sector are given much higher valuation by the majority of analysts, which includes continuous upgrades of target price.
Second, the glove sector, which on the contrary met a very different fate. It captured the market’s imagination in 2020 when its share price reached astronomical heights before plummeting in 2021 and in some cases close to pre-pandemic levels. It was as if Covid-19 never occurred.
Despite the glove sector’s explosive earnings amounting to multiple years consolidated in the past year alone, the share price has been falling.
Interestingly, valuation contraction has been happening in spite of earnings expansion, with many analysts downgrading the target price irrespective of the results reported.
Both examples clearly show that the stocks’ performances are driven by completely opposite “consensus” narratives from analysts and fund managers. The “consensus” view towards the tech sector is this: “while the share price is frothy, the prospect is bright, hence demands a higher valuation.”
The “consensus” view towards the glove sector, on the other hand, is: “while the earnings are good, the share price is cheap, the prospect is dim, hence commands a lower valuation.” This is despite both sectors being in the cyclical sector.
Even if tech sector growth is exponential, how long would it take for their actual earnings to catch up to the glove sector? Looking at Table 2, you would notice the vast disparity in earnings improvement versus the share price performance in Table 1 for companies in both sectors. This is an important distinction.
Human beings by nature are communal beings. It is hard to live in isolation from others. In order to fit in, most would seek to be a part of consensus rather than sticking out like a sore thumb. This is called “comfort in consensus”. Abiding by the majority’s view would always put you in a less conflicted state.
The danger lies when objectivity is compromised as a result. This is particularly apparent in the stock market. During a bull run, you see the herd mentality pushing stocks to great heights.
Conversely, during a bear market, everyone rushes to the gates triggering a panic selloff. At this point in time, research analysts would then play an important role as their expertise, integrity and objectivity would help restore some sanity to the market. Nonetheless, if analysts’ views were to be affected by their peers, the outcome will be a scenario of falling victim to “consensus”. This is detrimental to the companies under analysts’ coverage, investors and creates an inefficient stock market.
Recently, Hartalega Holdings Bhd’s earnings report for the first quarter (Q1) of financial year 2022 (FY22) exceeded all analysts’ consensus by a huge mile. An institution-centric foreign bank which gave Hartalega a target price of RM5 prior to the results being announced, admitted that he underestimated Hartalega’s average selling price (ASP) by a whopping 53%. Later, the analyst increased his earnings’ forecast for FY22 by a huge 65% in his report. However, he maintained the lower target price of Hartalega despite being completely wrong in the first place. His justification of his flawed analysis was stated in the headlines of the report “The future matters more than the past.” When earnings beat your forecast, you cannot then upgrade future earnings forecast but maintain the same target price. It defies common sense. This is precisely why retail investors at times feel frustrated and suspect the stock market is rigged against them.
Today’s investment landscape has changed a lot compared to the past where market participation was largely skewed towards institutional clients. Bursa Malaysia on July 28 said the new CDS account opening increased by 67% from 88,080 to 147,091 in the first six months of 2021. A total of 64% of the new account holders are aged between 25 and 44 years old. This influx of “millennial retail investors” in part is due to the lower cost of entry and low interest rate environment. If research houses’ focus remains on “big clients” (institutions and funds) and neglect the “small clients” (retail investors), then they are risking undermining a potentially potent force of the stock market.
Seth A Klarman, billionaire value investor once said, “There is comfort in consensus; those in the majority gain confidence from their very number.” I would like to add, “consensus” is not the equivalent of being right, thus, confidence can be misplaced. Successful investors are few and far between because they do not blindly follow the majority’s view. If research houses hope to win the heart of retail investors, it is imperative for analysts to be objective in their reports. It is alright to be wrong so long as the methodology or approach used is consistent and reasonable.
To put it bluntly, if retail investors think the system is gamed, they may shun the stock market and that will be bad for the market’s vibrancy. Personally, I do not wish to see that happening, especially with the recent influx of retail investors were decades in the making.
Ng Zhu Hann is the author of “Once Upon A Time In Bursa”. He is a lawyer and a former chief strategist of a Fortune 500 Corp. The views expressed here are his own.