Analysts were slow to react to BP's massive problems. But today, at 400p, is the reward worth the risk?
Last month, Joshua Brown wrote in a blog post that Wall Street analysts blew their analysis of BP (LSE: BP) because they're a bunch of ... fundamental analysts.
Brown, a money manager and blogger, is always entertaining and to the point. I believe he badly misfired on this one, however.
His post was in response to a Reuters report that nearly every Wall Street analyst stuck to their ratings as the Gulf crisis unfolded. As BP shares began to drop, "most were screaming the same message: buy, baby, buy."
Why did nearly every analyst miss so badly? Reuters says the BP mess once again exposes "the conflicts and weaknesses that still bedevil the sell-side analyst community, despite a decade of much-heralded reform." In other words, analysts are still hesitant to be negative toward companies that can provide huge amounts of underwriting business.
Santa Clause and the Tooth Fairy
Brown has a different opinion, blaming the blown calls on fundamental analysis, which looks at a company's financials, competitive position, management, etc., in order to come up with a fair value estimate.
Contrast that with technical analysis or momentum investing, which ignore a company's fundamentals and focus on share price movements, trading volume, and other things unrelated to the underlying business.
"For some strange reason," Brown writes about fundamental analysts, "they've been indoctrinated with this belief that discounted cash flow analysis and terms like 'Fair Value' will mean anything at all in a market of buyers and sellers relentlessly seeking advantage over each other." Cutting to the chase even more: "DCF is the tooth fairy, Fair Value is Santa Claus."
Brown says the BP crisis is so full of unknown risks and uncertainties that believing that a fundamental analyst's "model" can provide answers "is the height of slapstick-comedy-masquerading-as-research."
What a Fool fundie believes
Brown misses in two ways here. First, most analysts don't even use DCFs to value companies. A survey by New York University professor Aswath Damodaran a few years ago revealed the majority rely on relative valuation -- which is mostly about comparing similar companies to each other and then determining which are undervalued on a relative basis.
But -- Brown's shots at DCF and fair value aside -- that's a rather minor point. His biggest misconception is that fundamental analysis somehow excludes the concept of saying, "No one -- no one! -- knows what BP's bill will be and how long it will be paying," and therefore it's crazy to perform a DCF on the company.
In fact, a fundamental analyst did say that: Tom Jacobs, head of our US Motley Fool Special Ops service. His initial research on BP focused on one question: "Is the potential reward worth the risk?" Because of the still unknowable downside compared to a quite limited near-term upside of around 50%, Tom decided the potential reward was not worth the risk and moved on. That seems like sound fundamental analysis to me.
Responsible fundamental analysis most certainly considers risk vs. reward. The fact that nearly every analyst failed to get it right speaks more to the still-tangled web of investment banking relationships than a failure of fundamental analysis.
Foolish bottom line
Things are always so clear in hindsight. Of course BP was a buy when its shares hit as low as 300p just a few weeks ago, right? But, in the moment, things aren't always so clear.
If you're going to take on the extra risk in special situations like BP, you need a lot of upside, probably more than what BP is offering today at 400p. Otherwise, it's just not worth it. Whether you're a fundamental analyst, technical analyst, or fortune-teller.
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> A version of this article, written by Rex Moore, was originally published on Fool.com. Bruce Jackson, who still has an interest in BP, has updated it.
