Tricks and traps in share price targets

PORTFOLIO POINT: They’re an easy trap for investors, but used properly brokers’ share price targets can be very useful.

The worst possible situation for an investor who decides to join the rally is buying in after a stock has peaked, or is about to go nowhere.

Enter consensus price targets.

Over the years I have developed a great affection for consensus price targets as I have come to understand how to interpret them and how to apply that knowledge when it comes to picking tomorrow's winners.

Where most investors go wrong is by assuming that a big gap between share price and stockbroker price targets indicates there's a bargain up for grabs. This can sometimes be the case but more often than not the market has come to the conclusion that what appeared to be a bargain yesterday has turned into a dog today. And in most cases it will still be a dog tomorrow.

But today I want to highlight the indisputable value of consensus price targets and how they indicate where a natural ceiling lies for a specific stock. The simple reason I tend to look at consensus targets instead of targets set by individual stockbrokers is that they work much, much, much better.

When bearish analysts think a certain stock is not worth more than $5, while their bullish colleagues believe it could trade up to $10, practice shows it is likely to find a ceiling around $7.50.

At that point the second group will continue rating the stock as buy or overweight or outperform, potentially setting up a “broker trap” for investors who are not paying attention to the wider picture.

Let me first point out that no one single method works every time and under all circumstances. We're talking about the stockmarket here, which harbours “risk assets”, so there are no watertight guarantees.

But there were so many good practical examples that have occurred lately I thought I might share them with you to illustrate the value of why investors should pay attention to consensus price targets.

Towards the end of 2009, shares in JB Hi-Fi (JBH) surged above $23 where they traded sideways for about a month. They then started weakening into the new calendar year. At the time, this was around where the consensus price target had settled following a wave of stockbroker upgrades (for more on JB Hi-Fi, see today's ValueLine column: click here).

One very bullish stockbroker – RBS Australia – had gone as far as to lift its price target to $26.50, but most others wouldn't go further than $22–24.

Any investor who owned the stock at that time, and who would have observed there was no gap left to fill in between share price and consensus price target, should have asked the question: what are the odds that broker targets are about to be raised further? And if this happens, what are the odds to see significant increases?

The reason why is because practice shows most share prices tend to run into selling pressure when moving above consensus price targets, and JB Hi-Fi proved no exception. By late January, the shares sank below $20 and they have been unable to sustainably rise back above that price level.

Again, the reason why is no secret. Stockbrokers soon came to realise their expectations were probably a bit too bullish and price targets have since come down towards the $20–22 range. As a result, today's consensus price target now sits at $21.56, about 11% above where the share price is now.

An important observation to make is that share prices often retreat even if broker price targets remain unchanged. Observe, for example, Iress Market Technology (IRE). The share price has repeatedly tried to rise beyond $10 this year – first in January, then April and again in June.

On the first two occasions, the share price subsequently fell below $8, which makes for a rather big fall (especially for investors who bought in close to the top and couldn't bring themselves to sell at a loss).

After the third attempt the shares still fell to near $8. The difference between JB Hi-Fi and Iress is that in Iress's case, stockbroker price targets have actually moved higher over the past weeks, but not enough to support a share price beyond $10.

As things stand right now, the gap between share price and consensus price target only suggests potential upside of low single digits (about 3.5%, ex-dividend). Recent history shows, the Iress share price can again rise higher, but can it remain at such elevated price levels?

Current market expectations are for the company to report a jump in earnings per share of some 27% for calendar 2010, but only for a 10% EPS advance next year. It would probably require a substantial lift to the 2010-11 consensus forecast before broker price targets will move significantly above $10.

In the meantime, investors ignore the “natural ceiling” above the Iress share price at their own peril.

There is a third variation to this theme. Shares in Cochlear (COH) have continued to trade above their consensus price target since March. Not surprisingly, in the lead-up to the August results season the company had been often mentioned as one that was likely to beat market expectations with its upcoming 2009-10 results.

Instead, Cochlear’s 2009-10 release has caused most securities analysts to lower future growth expectations. After another year of near 20% profit growth, consensus forecasts are now for 13% and 12% only for the next two years – still double digits, but probably not enough to warrant a price/earnings (P/E) multiple of more than 22.

If these forecasts remain largely unchanged, the stock will look expensive, trading on a multiple of 22 times 2010-11 consensus EPS forecast. In earlier analyses on the healthcare sector, I have stated that Cochlear has the potential to become tomorrow's CSL (CSL) – certainly the same basic characteristics seem to be in place: high multiples with sharply lowered growth prospects.

(In case you've missed it: shareholders who bought CSL shares prior to the March rally in 2009 have not only completely missed out on the rally, but the market value of their shares has gone backwards over the period).

Of course, there are many more examples, but I could not possibly review them all at once. The last time I checked, there were in total 15 stocks above their targets, including Whitehaven Coal (WHC), Elders (ELD) and GPT (GPT).

Investors should be aware that stocks do not necessarily always trade on earnings expectations only. Sometimes other factors, such as takeover speculation, are dominant. And, of course, sometimes the market simply moves ahead of a general adjustment in stockbroker forecasts.

In most cases, however, investors are likely to find that paying attention to consensus price targets is a worthwhile effort to make.

Rudi Filapek-Vandyck is editor of FN Arena, an online news and analysis service.