Wednesday, February 10, 2010

GameStop: Filtering Out The Useless Information

Research analysts receive a lot of flack when their predictions are dead wrong. Since they are supposed to spend their working hours immersing themselves in the vagaries of the various businesses under their study, investors hold them to a higher standard when events occur that went unforeseen. But the research analyst has two separate jobs, and in only one of these can realistic expectations exist.

First, the research analyst must predict the company's future results. To do this, the analyst must understand the industry and business risk and success factors. Analysts will study and speak to the company's customers, competitors, suppliers and management. Much useful info can be gleaned from such study, as discussed by Philip Fisher, one of the pioneers of this approach.

But the world's greatest investors will tell you that the analyst's second task is virtually impossible. Unfortunately, they all try it anyway. Accompanying each analyst report is a target price, where the analyst tries to make sense of market movements and estimate not what he thinks the company is worth, but what the market will think it is worth. If there ever was a futile exercise, this is it. But the analyst will spend enormous amounts of time stringing together long calculations of high precision - and low accuracy - in formulating an expected price as soon as a few months out.

Predicting the market's short-term movements is a difficult task indeed. Even if it can be done, which would be disputed by Warren Buffett and a slew of top investors and market observers, diagnosing short-term market movements isn't within the research analyst's expertise. At times, this can lead to a divergence between the analyst's opinion of a company's business conditions and stock expectations.

For example, consider a note yesterday issued by Gary Balter of Credit Suisse. Balter downgraded GameStop (GME) to "neutral" even though the share price is more than 20% below his price estimate. So despite an "exceedingly exciting valuation" and a "limited downside", Balter doesn't see the market recognizing these factors, as he is worried about a situation where "even better results do not expand the multiple".

Analyst reports can be extremely useful, offering business and industry insights from those who have spent months studying companies under their research umbrella. However, investors must separate what information in the report is useful (business risks and opportunities) and what is nothing more than rampant speculation (estimates of short-term market prices).

GameStop certainly has business challenges; that part is not in dispute. Pricing pressure from big-box retailers, and the potential for digital downloads to grab share in the future all have investors scurrying to the exit. The point, however, is that investors should base their investment decisions on what the business is worth, and not on what they predict the short-term market price to be, for the latter cannot be done.

Disclosure: Author has a long position in shares of GME


Anonymous said...

Excellent points. I did a risk analysis and found that Gamestop has good business model around used games and big box retailers doesn't. That doesn't mean to count out Amazon. however, Gamers would like to love go and see what's on the shelves and feel them.

Coming to second risk, digital downloads, I saw somewhere that Gamestop has hired an Executive to come up with a strategy. This is definitely a sign of understanding of the evolving markets and I have asked hard core gamers who are colleagues of mine and found out that they buy games for consoles and only for PCs they try to download digitally and Digital downloads have some DRM difficulties and the companies have a long way to go.

Hope this helps.

Rayhaan said...

Yo saj, Even though their is a m.o.s here, but despite that isnt this an intensely competetive industry especially considering digital downloads and free downloads that any teenager wid a modem has access to! I mean why bother with paying 4 the games wen u ve torrent! P s read the snowball thx 4 the review, how bout reviewing damn right!?

Saj Karsan said...

Hi Rayhaan,

Yes they certainly have some competitive challenges facing them.

I don't know that book, I'll take a look.

rayhaan said...

i mean the book about charlie munger i guess