Highlighting the Detonator is Critical for Making Great Stock Calls
It’s January and the analyst is forecasting a $75 stock to be at $100 by year end, based on the company’s “visionary management team” and “innovative products.” Over the course of the year, the analyst writes 7 research reports about the stock, updates his model 4 times and makes 9 presentations. Now it’s December and the analyst continues to pitch the company as having a “visionary management team” and “innovative products,” but the stock hasn’t budged from $75. What was missing from the analyst’s stock call? The element absent all too often…a catalyst.
Basing stock calls on broad concepts like “great management,” “leading market share,” “synergy,” and “efficiency gains” is pointless unless the market’s perception of these is going to change materially over the investment time horizon, usually driven by unexpected upward earnings revisions (downward for shorting a stock). It’s for this reason I caution analysts, if they don’t have an out-of-consensus earnings forecast, their stock call isn’t likely to work.
A stock call without a catalyst is as effective as an unloaded gun
In preparing to write Best Practices for Equity Research Analysts, as I was cataloging the countless best practices for stock picking, I realized a step needs to be dedicated to this important concept of identifying a catalyst, which is the “I” in our TIER™ framework. The three steps for ensuring you’ve identified a catalyst are highlighted in the table below:
| Step | Process |
|---|---|
| Step 1: Identify & forecast potential catalyst(s) |
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| Step 2: Focus on catalysts that meet the optimal criteria |
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| Step 3: Proactively prepare for next catalyst |
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Here are four key perspectives that pertain to identifying and forecasting a catalyst:
- Ensure your catalyst has a defined timetable: Predict the catalyst before recommending a stock, or suffer the risk noted by John Maynard Keynes when he said, “Markets can remain irrational a lot longer than you and I can remain solvent.”
- Don’t equate a “cheap stock” to a “good idea”: Avoid recommending low-valuation stocks simply because they are “cheap” – often stocks are cheap for a reason, otherwise known as a value trap. Identify a reliable and likely catalyst that will make them “less cheap.”
- Review “value” stock calls that no longer screen as “value”: If a stock experiences a strong move and no longer looks cheap, identify the catalyst that will justify higher valuations or attract a new class of investors (e.g., GARP or growth) before assuming the stock will move any higher.
- Use “change in valuation” sparingly: Stock recommendations tend to fail when they are based solely on the analyst’s expectations that: A) the stock’s valuation multiple will be re-rated (void of an impending financial forecast change); or B) the market will change its preferred valuation methodology
A gun without a bullet is just a piece of metal, and similarly a stock call without a catalyst is just a lot of noise (and potentially hurts your reputation). If you correctly identify and forecast the catalyst, you’ll have that loaded weapon that, over time, will bring the market around to your out-of-consensus view.
This Best Practice Bulletin™ targets, #3. Make Accurate Stock Recommendations, of GAMMA PI™, within our Pathway to Success Framework.
Let me know if this Best Practice Bulletin™ helps and how I can improve upon this best practice. If you’re interested in exploring this topic further, AnalystSolutions provides equity research training with a specialized workshop to help Master the Stock Call Techniques of Highly Experienced Analysts.
Improve you or your team’s stock picking and communication skills with our equity research analyst training tools, which includes workshops such as the one above, as well as our GAMMA PI™ assessment and one-on-one coaching. Also, consider ordering the book that inspired the founding of AnalystSolutions and the Best Practices Bulletin: Best Practices for Equity Research Analysts.
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©AnalystSolutions LLP All rights reserved. James J. Valentine, CFA is author of Best Practices for Equity Research Analysts, founder of AnalystSolutions and was a top-ranked equity research analyst for ten consecutive years
