By Nancy Zambell
Editor, Investment Digest
and Dividend Digest
3 Reasons to Beware of Analyst Ratings
Buy and Hold, Just Don't Sell
Does Outperform Mean Buy?
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In my Daily Alerts for the Digests, I often point out when an analyst initiates coverage or changes coverage or price targets on one of our contributor's recommendations.
I do that so that my readers are aware of what others in the investment community are saying about their stocks. But you shouldn't take analysts' recommendations as the Holy Grail-for a number of reasons.
1. Analysts are predisposed to recommend companies that bring business to their firms.
The 1929 stock market crash brought to light the blatant and unregulated insider trading that permeated Wall Street. One of the results of that catastrophe was the Glass-Steagall Act of 1933, which created the Chinese Wall-the supposed separation between a brokerage company's research and its investment banking divisions.
Until then, brokerage firms underwrote and issued stocks for companies, and their research departments hyped those stocks to their retail customers, always with glowing recommendations-whether or not they merited it. The goal was to sell the stocks and make their investment clients and themselves-not their retail customers-rich.
The Glass-Steagall Act and the Chinese Wall were supposed to end the wholesale bias of research ratings, by preventing investment bankers from interacting with research analysts. But in reality, that never happened.
In most brokerage firms, the majority of the research reports are still written on behalf of the firm's investment banking clients. And even in the boutique brokerage firm for which I plied my trade in the 1990s, it was routine for a research analyst to be not-so-gently persuaded to write up a positive report on one of the firm's investment banking clients.
Because the system makes complete objectivity difficult, investors need to be ultra-vigilant when it comes to digesting analyst reports.
2. Analyst recommendations aren't all that accurate.
Last year, nerdwallet.com analyzed Wall Street analysts' ratings on the Dow 30 stocks in 2012. Here's what they found:
More than 70% of the analysts' buy ratings were accurate. But when it came to "hold," only 20% were correct (see the following graph).
And forget about "sell" ratings! In analyst parlance, that term hardly ever appears. After all, they can't put a "sell" rating on their investment banking clients' shares, can they? That could lead to a boycott of the firm. Consequently, shares that the analysts don't like are given "hold" ratings, and "sell" ratings are generally confined to companies that don't do business with the brokerage firm. In NerdWallet's report, the number of sells was so small (33 out of 883), they were statistically irrelevant.
Just look at Apple (AAPL), if you want a good example of how wrong an analyst can be.
In a January 28, 2014 CNBC clip, Bert Dohmen, president and founder of Dohmen Capital Research Institute dissed Apple (AAPL), saying that he had "a long-term downside target of 45" (after the recent 7-1 stock split), citing the company's declining profit margins and lack of technological innovation.
In fairness, Dohmen wasn't the only analyst to dump on Apple. Analysts from Oppenheimer, Raymond James, Wells Fargo, Barclays and many others-showing the typical Wall Street herd mentality.
But look at what has happened to Apple's stock since then.
Bottom line: It pays to be wary of analyst ratings.
3. It's difficult to decipher analyst ratings.
One of the biggest complaints that I hear from investors is that they can't understand analysts' ratings. That's because their terminology is often obscure. Just look at this chart that the Financial Industry Regulatory Authority (FINRA) put together in an attempt to explain the ratings systems of three brokerage firms:
Clear as mud, right? The only thing that's clear is that it's almost impossible for an investor to interpret these ratings to actually determine if a stock is a buy, hold or sell.
Now I'm not beating down all analysts. The fact is, as NerdWallet showed, they're right 51% of the time. And sometimes they do go against the herd. Look what happened with Facebook (FB) this year.
According to Bloomberg, in March, 16 of the 49 analysts covering Facebook published price targets of well-below the 70 that shares were trading at. While those 16 undoubtedly celebrated when the stock went down, the others are probably not counting on big bonuses this year.
My point is this: Don't take analyst ratings (if you can figure them out) to heart. There are just too many conflicts inherent in the system. But that doesn't mean you should ignore them. I like to look at analyst reports for two important reasons:
You can use them as a starting point to get ideas. Then, do your own investigation to see if you agree with their outlook, and if so, determine if the stocks they are recommending would be a good fit for your portfolio.
Analysts write fabulous industry reports, so if you happen to be a customer of a brokerage firm with a research department, I recommend that you take advantage of reviewing the industry/sector reports they issue. They usually go into great detail, and will give you a fabulous overview of any number of industries.
Just for fun, I took a look at the most recent analyst ratings changes for one day last week (July 11). There were 14 initiations (on 13 companies), 9 upgrades and 9 downgrades.
I told you it was confusing, didn't I?
By the way, if you want to track the analysts' recommendations, here are two good websites:
And, hopefully, the chart above will help you weed through some of the undergrowth to determine exactly what the analysts are saying. Take the information as a tip and do your homework, and you just might find a few hidden gems that will be perfect for your portfolio.
Editor of Investment Digest and Dividend Digest
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