Uncertainty and changing recommendations
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Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.
At a recent gathering of subscribers it became apparent there is confusion around the reasons behind the changes in recommendations as the share price changes. Some subscribers were of the opinion the changing recommendations reflected a bias towards "day traders" rather than long-term investors.
This could not be further from the truth and clearly this misconception must be addressed.
Firstly, the fair value estimate calculated by the analyst is derived from a three-stage discounted cash flow model. It is the analyst's best estimate of fair value after distillation of numerous assumptions which influence a company's cash flow, as well as other factors including cost of equity and cost of debt.
This estimate will not change unless there is a change to the fundamental position but will increase modestly when the model is rolled annually (usually after profit results) to account for the time value of money.
While the fair value estimate is a precise figure we are not so egotistical to declare it as a certainty. This is where the uncertainty rating comes into play. How certain is the analyst of the estimate?
In the case of resource companies, where there are numerous variables including metal prices, grades, currencies et cetera, there is a higher uncertainty compared with a healthcare company. So, the uncertainty rating will be higher.
The higher the uncertainty rating, the greater margin of safety required to address issue. Consequently, the setting of the recommendation price triggers will reflect the uncertainty rating.
Exhibit 1 shows the discount to fair value or the margin of safety required at different levels of uncertainty.
Exhibit 1: Margin of safety bands for each level of uncertainty
Source: Morningstar Equities Research
Once the fair value estimate is set, the market takes care of the recommendation. As the share price changes so can the recommendation, particularly if the price is near a trigger point.
A subscriber used the volatile Monadelphous (MND) as an example of changing recommendations. A visit to the site shows there have been seven changes in recommendation since 21 August, while the fair value estimate was unchanged at $8.50.
This reflects the volatile share price (where the price has moved up to 1 per cent from day to day). The share price has hovered around the Accumulate/Hold trigger and any movement above or below the $6.80 trigger would result in a change in recommendation--upgraded to Accumulate on a fall below $6.80 and downgraded to a Hold on a rise above $6.80.
Hopefully, this clears up the issue. But should you have any questions please contact the help desk on 1800 03 44 55, or email firstname.lastname@example.org
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