5i Research Blog
Feb 13, 2017 Target prices now added to our reports!
Members of 5i Research are likely well aware that we are not big fans of price targets for stocks. They tend to encourage short-term trading, are used as a marketing tool and often lead to investors who follow them doing the wrong things at the wrong time. As an example, let us assume a company has a great quarter and the shares shoot up, blasting through consensus target prices. Many investors would be inclined to sell a stock at this stage. However, there is likely a reason the quarter was strong and the shares rose. In fact, the prospects at the company may be better than ever and analysts may be sharpening their pencils to increase the target. Selling a stock just because it reached an arbitrary price can cause an investor to sell way too early and also lead to an investor selling the good names and holding the bad investments that never reach their target prices.
Alternatively, if a stock is dropping and the differential between the target and the current price grows, this may entice an investor to continue to hold what could be a poor company with declining fundamentals. Meanwhile, the potential implied return could be in the double digits. What a deal! Except something is likely being missed here. At the end of the day, a price target tries to give a static value to a very fluid company and investment climate that can be impacted by events at the company, at competitors’ companies, in the country of headquarters and international events, not to mention investor sentiment and moods.
So if target prices are so bad, why are we adding them to our reports?
The decision behind investing in a stock often comes down to two factors: The quality/fundamentals and the valuation. We think our current reports are quite effective at pinning down the quality of a company and we are believers that over the long-term, good companies will continue to be good companies and justify their valuation over time, all else equal. We always think of Warren Buffet’s quote when thinking about valuation: “It is far better to buy a wonderful business at a fair price than a fair business at a wonderful price”. So, at the end of the day we think if investors can find those wonderful companies, everything else should work itself out over the long-term.
With that under consideration, we can understand an investor not wanting to add a full position in a stock after it is up 100% and looking pricey in the short-term, even if the prospects remain strong. So we wanted to provide one more metric the investor can use to justify the risk/return tradeoff. As an example, a share price may be way below the target price. This could indicate the stock is very cheap or the market views it as a ‘bad’ company relative to peers. Hopefully, overlaying this with the context of the rest of our report can give more of an idea as to whether the stock is ‘good cheap’ or ‘bad cheap’. Looking at it the other way around, if there is one good company out of a group of peers that are terrible, the valuation will almost certainly be at a premium to the peer group. Understanding the degree to which the premium is, allows the reader to make the call of whether a certain degree of premium is justified.
Finally, this also helps to highlight the type of gain potential for a stock. As we noted earlier, a share can grow through growth in fundamentals or growth in the trading multiple it is awarded. One is easier to predict/uncover in our view but both can lead to returns. One stock may be in an out of favour industry or had a bad earnings release and is trading 25% below its implied market price based on relative valuations or maybe it is just not as good as the peers. While it may be less likely to grow through improved earnings or some other factor, there could be some chance for growth in the valuation alone. On the other hand, a stock could be sitting at a 25% premium to peers. But if it is growing at 50% rates, this is likely not a problem. This does however show an investor that future returns are more likely to be from growth in revenues or the bottom line opposed to an ever-expanding multiple. One is not necessarily better than the other, but it is another tool with which one can use.
Members can login to see how to utilize these targets and also view our recent report with the target price. Not a member, join us now to see this change as well as a recent trade idea.