Using Sentiment to Gauge Valuation

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Using Sentiment to Gauge Valuation
by Greg Forsythe, CFA, Senior Vice President, Schwab Equity Ratings®, Schwab Center for Financial Research
August 8, 2006

The most fundamental issue of equity investing is deciding whether a company's stock price represents "fair value." Many academics believe focusing on this issue is a waste of time because they claim the stock market is "efficient." In an "efficient market," current stock prices reflect the collective wisdom of all investors—in other words, there are no mispriced stocks. If you agree, you should buy a low cost index fund.

However, if you believe the market is not perfectly efficient, how can you systematically determine whether a stock might be mispriced?

Rather than relying on the collective wisdom of all investors, we're going to show how some market participants appear to be wiser than others, and consequently, how watching the behavior of these "informed investors" can help you spot potentially mispriced stocks.

The concept of "valuation sentiment"
As an individual investor, you should be aware of three very important institutional forces at work that influence stock prices:

Advice providers, such as brokerage firm analysts
Asset managers, such as investment advisors managing equity mutual funds
Corporate officers, such as Chief Financial Officers electing to issue stock

These institutional players have strong incentives to identify investment opportunities, or more specifically, potentially mispriced stocks. For example, advice providers know they will get paid more if the stocks they recommend perform better than market averages. Asset managers know that their fees will grow if the equity funds they manage outperform their benchmarks. Corporate officers know that shareholders can benefit from judging the best time to issue shares or execute share buybacks.

By examining what these institutional participants are saying and doing, we can create valuation sentiment metrics—indicators of whether these professionals believe a particular stock is potentially undervalued or overvalued.

Valuation sentiment indicators: good and bad
With some thought and creativity, it's possible to create a number of valuation sentiment metrics from research databases containing thousands of stocks back through many years of history. For each metric, we ask, "Are subsequent stock returns correlated with initial values of the valuation sentiment indicator?" Let's review some important research findings.

1. Advice providers
The most obvious and readily available metric in this category is the buy/hold/sell ratings assigned by brokerage analysts to the stocks they cover. It's logical to assume that highly-rated stocks reflect a consensus sentiment that analysts feel they're undervalued, and that poorly-rated stocks are believed to be undervalued.

Unfortunately, brokerage analyst consensus ratings fail the test of being useful valuation sentiment indicators. Research by Schwab and several independent academics has found that stocks rated highly by analysts do not perform better than market averages, and often perform worse! One useful aspect of brokerage analyst ratings is worth noting, however: when they receive new information that impacts the stocks they follow, they change their ratings to reflect the new information. Those changes can be an indication of future performance, even though the ratings themselves don’t seem to be useful as valuation sentiment indicators.

The only other empirical research I've seen that fits within our "advice provider" category is a few studies on the performance of equity-focused newsletters. These studies have shown that as a whole, stocks preferred by equity newsletters perform no better than market averages.

2. Asset managers
One way to capture the valuation sentiment of institutional asset managers is to measure the proportion of each stock's outstanding shares held by institutional investors. It's logical to assume that widely held stocks reflect asset manager sentiment that these equities are undervalued. But empirical research on institutional ownership is mixed. The problem is that institutional ownership is really a better indicator of trading liquidity than valuation sentiment, and is further distorted by the passive holdings of index funds. Only when passive holdings are excluded and comparisons are limited to stocks of similar size and liquidity does it appear that more widely held stocks outperform their less widely held peers. Unfortunately, these adjustments are beyond the means of individual investors.

However, there is one subset of institutional investors worth paying attention to—short sellers. It's logical to assume that stocks with the most shares sold short reflect a sentiment among investors such as hedge funds that those stocks are overvalued. Indeed, research by Schwab and several independent academics has found that stocks with the highest short interest—that's total shares sold short as a percentage of shares outstanding—do tend to underperform market averages.

3. Corporate Officers
Corporate managers clearly have a unique inside view of their firms' prospects. Therefore, it's logical to assume corporate decisions to issue or buy back their common shares may reflect management sentiment as to whether the current stock price is expensive or cheap. Research by Schwab and several independent academics has found that companies issuing stock in either initial public offerings or follow-up secondary offerings do tend to subsequently underperform market averages, while corporations that reduce their shares outstanding through open market repurchases tend to subsequently outperform.

Another way to capture corporate management's valuation sentiment is to track the personal trading of corporate officers in their firm's stock. It's logical to assume that corporate insiders buying stock reflect a sentiment that the stock may be undervalued, though insider selling may reflect much more than the insider’s sentiment that the stock is overvalued. After all, a corporate officer may sell shares for reasons such as option exercises, portfolio diversification, buying a new house, etc. Empirical research on insider trading has been mixed, but most studies conclude that insider buying can be a useful valuation sentiment indicator, while insider selling provides little predictive information.

How to use valuation sentiment
How can you use valuation sentiment indicators to improve your portfolio performance? Just as medical doctors vow to "do no harm," you too must first make sure you don't rely on ineffective valuation sentiment indicators or misuse potentially useful indicators.

Don't use consensus analyst ratings alone to make buy/sell decisions. From a sentiment perspective, it should be no surprise that collective analyst sentiment has little predictive power. If everyone is already recommending a stock, who is left to buy and push the price up further?
Don't get lured in by the sensational advertising claims of many equity newsletters. Most of these geniuses and gurus underperform. If you want to find the rare good newsletter, consult the Hulbert Financial Digest, a newsletter that monitors the long-term performance of other investment newsletters.
Be wary of Initial Public Offerings (IPOs). Aside from the fact that these firms are usually young and unproven, remember that in an IPO you are either buying shares from insiders who are selling, or are buying shares newly issued by the corporation, neither of which suggests the stock is undervalued.
Consider avoiding or selling stocks that short-sellers hate. Check out a stock's short interest, which is compiled monthly by the New York Stock Exchange and Nasdaq and published in the Wall Street Journal and Barron's.
Think again before buying stocks of firms issuing large amounts of common shares to fund their growth. If these firms thought their stocks were undervalued, they would utilize other financing options.
Don't get fooled by companies announcing their intention to buy back shares, as companies often don't actually follow through on those announcements. Other firms tell you how much they spent on buybacks, but fail to state that these buybacks offset employee stock option exercises rather than actually shrinking the share base.

If all this sounds like a lot of work, then perhaps a better alternative is to consider using Schwab Equity Ratings. Several of the equity analysis concepts underlying Schwab Equity Ratings relate to value, valuation sentiment, and investor sentiment change. Consequently, Schwab clients can take advantage of the research findings shared with you here, along with many other valuable research concepts, by using Schwab Equity Ratings. What a great way to save research time, and hopefully, enhance your portfolio's performance as well!

The Schwab Equity Ratings® are not personal recommendations for any particular investor. They do not take into account the financial, investment or other objectives and may not be suitable for any particular investor. Before buying, investors should consider whether the investment is suitable for themselves and their portfolio. Additionally, investors should consider any recent market or company news. Stocks can be volatile and entail risk. Individual stocks may not be suitable for any particular individual investor. While A- and B-rated stocks as a group have outperformed D- and F-rated stocks as a group, individual stocks have performed differently than the group as a whole.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

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