Fundamentalists tout past earnings growth as a most reliable indicator of future growth. But academics have shown that past earnings growth are no help in predicting future growth.
Why is the Crystal Ball So Clouded?
- Many of the influential changes that affect earnings prospects are unpredictable.
- Creative accounting procedures produce dubious reported earnings, e.g. pro forma earnings, pushing due payments to future years, etc.
- Analysts may make errors, e.g. over-estimating the market size. Analysts also tend to copy each others' forecasts.
- The best analysts go to the sales desk or to hedge funds.
- With discount brokerage firms and competitive commissions, analysts' main buck comes from new issues and trading profits. Analysts don’t want to piss off the companies that they cover.
Do Security Analysts Pick Winners? The Performance of the Mutual Funds
From 1992 to 2017, the S&P 500 has had 9.69% while the average equity fund has had 8.55%.
Furthermore, above-average funds for 2 decades in a row fit into the laws of chance.
The Efficient-Market Hypothesis (EMH)
Weak Form: past stock prices do not influence future stock prices. That is, TA is useless.
Semi-Strong Form: no public information will help the analyst select undervalued securities. The balance sheets, income statements, dividends, etc. are already reflected in the market’s price.
Strong Form: nothing that is known or even knowable about a company will benefit the fundamental analyst. If there are intelligent investors buying/selling stock, then existing stock prices will already have their future prospects discounted in them. To the passive investor, the pattern of stock prices makes one stock as good/bad as anything else.
EMH does not imply that stock prices are always correct (they aren’t). EMH implies is that no one knows for sure if stock prices are too high or too low.