Risk Latte - A Game to Reward the Equity Analysts

A Game to Reward the Equity Analysts

Rahul Bhattacharya
November 3, 2006

Last December, a group of (some say, they were fifteen in number) disgruntled equity analysts met in one of the City's famous watering holes to vent frustration and anger on not receiving million dollar bonuses. They were all from different banks. They had all made million dollar bonuses once upon a time regardless of the market moves and regardless of how they called the market. But surprisingly last year, in the thick of the bull market, when all of them had more or less performed astoundingly by calling the market up, their banks had refused to hand them the money they deserved.

These analysts all followed a stock called ShitTech which was, in early 2005, trading at $15. The stock had gone to $150 during the bubble and then come down to $2 but luckily as it was about to vanish from the trading screens it caught the tail of the bull and eventually made it way back to the level of $12 by the end of 2004. All these fifteen or so brilliant individuals had predicted at the start of year 2005 that the stock will go up from bottom of the ocean where it was languishing. One guy said it will go back up to $85 in a year¡¦s time, the other said $50, yet another said $35 for sure. Only one guy said it will go down to $9 and staked his career on it. During the entire year of 2005 the stock made wild swings and went up to as high as $45 but by December finally settled down at $16 or something like that. And most of these guys said that their views were vindicated. The management of their banks thought otherwise and awarded each one of them a year end bonus a trifle shy of a million bucks. What a blasphemy!

An investor who had followed all their research reports for long ended up making a huge pile of money on this stock and he was spot on in his forecast of the year end stock price. He simply took the average of all the analysts' forecast price.

That investor was, per chance, present in that watering hole that evening and he overheard their conversation. He felt a pang of guilt. It was really unfair that he made all this money by doing nothing but simply risking his capital and using a bit of brain whereas these bright individuals toiled hard all year round, wrote thick and dense reports and what not and got rewarded only with a seven figure annual salary and six figure bonus. So he walked up to them and said: "Gentleman, I am willing to give to one of you $1 million in a year's time under contractual agreement if you make a correct call this time. Shall we play a game?" As the legend has, call it the pressure of a divorce or the itch to get a Maybach, they all agreed.

What was the game? The investor asked each of these analysts to pick a value for the stock between $0 and $50 that he thought would be the value of the stock in a year' time, i.e. December 2006. Since the stock was trading at $16 so a fair estimate of the upper level of the stock was $50. The lower limit of $0 was for theoretical reasons. However, there was a condition. The analyst who whose estimate (forecast) will be 90% of the average value of all the estimates of all the analysts will get the reward of a million bucks.

So to win a million dollars the analysts will have to simply choose a value of between $0 and $50 for the stock and that value should be 90% of the average of all the values chosen by all the analysts.

Notice the simplicity of the game: it does not matter at all what the actual (or exact) value of the stock will be in a year’s time so the analysts can practically choose any number between 0 and 50. But the all that matters is that their choice should be as close to 90% of the average value of the group’s estimate as possible. The person whose number is closest to 90% of the average value of all the numbers (sum of all the analysts’ choices) will get the reward.

For the sake of posterity, the investor asked them to write the number on a piece of paper and put it in a safe box with the manager of the bar. They all agreed that they’ll come back on the last working day of December, 2006 and open the box and then the reward would be handed over.

Five minutes, a piece of agreement signed, a box full of numbers and the analysts went back to their beer And the investor felt so relieved that he had finally been able to mimic Warren Buffet in doing some charity.

  1. What value did most of the analysts chose? Any idea or clues?
  2. If you were one of them what value would you choose for the stock?

...... In the following article we will try to guess their answers. In the meantime try to see if you can get any clues, if not at least you may ruminate on the missed opportunities of becoming an equity analyst yourself.

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