Warning: It Can Be Dangerous to Listen to Wall Street Analysts

At least once a day, I point out to my colleagues some boneheaded move by a Wall Street analyst. Whether it’s downgrading a stock that’s already been cut in half… or needlessly raising the price target of a $100 stock by one or two dollars.

[ad#Google Adsense 336×280-IA]Case in point: last week when Credit Suisse raised its price target on Facebook (NYSE: FB) to $104 from $102.

Ask a hedge fund manager what he thinks of sell-side analysts’ research and the expression on his face will look like he’s eaten a month-old Brussels sprouts casserole.

Sell-side analysts are the “researchers” from brokerage firms and investment banks like Goldman Sachs, Morgan Stanley, etc.

These are the men and women often quoted by the press and whose upgrades and downgrades can move stocks.

In December, I explained why these analysts should not be listened to.

So why do I continue to go off on these people?

Because it’s dangerous to listen to them and it steams my britches to know that they still influence the buying and selling decisions of many investors.

(I used to be a sell-side analyst, so I know how the game is played. For details, please see the article I referenced above. Though you should know I worked for a firm that was considered the most contrarian on Wall Street. We didn’t follow the usual model.)

And now there’s even more evidence that you can do better on your own rather than listening to analysts.

This week, Barron’s published a study showing the performance of seven firms’ “focus list” stock recommendations. The focus list is a collection of the very best stocks among a firm’s buy recommendations – the plays that should generate the largest gains.

How’d that work out?

In 2014, only two of the seven focus lists outperformed the S&P 500. Morgan Stanley and Credit Suisse’s focus list recommendations returned 16.8% and 15.1% respectively. Meanwhile the S&P 500 (equal weighted) returned 14.5%.

Bank of America, Merrill Lynch, Goldman Sachs, RBC Capital Markets, Wedbush Securities and Stifel Financial Management all underperformed the S&P 500. Wedbush and Stifel actually posted negative returns.

Think about that for a second. In a year when the market was up double digits, the very best recommendations of these two firms not only didn’t match the S&P 500…

They lost money.

This reminds me of another story I like to tell. Back during the dot-com boom, BancBoston Robertson Stephens put eToys on its “must-own list.” It wasn’t just a buy. You must own it!

At the time, eToys was a $7 billion market cap company. About 18 months later, this “must own” stock went bankrupt. It didn’t just underperform the market by a few percentage points, it ceased operations.

Analysts are usually considered bright by most standards. But despite their book smarts, they’re lousy stock pickers. Maybe the constraints of the Wall Street system make it tough for them to do a good job. Whatever the reason, you shouldn’t listen to them.

Another study published in the Journal of Economic Behavior and Organization found that analysts often don’t respond appropriately to new information. According to the report, “many of those analysts stubbornly stick to their erroneous views of the company.”

That’s why I prefer to buy stocks that are widely disliked by Wall Street analysts.

As I pointed out, these folks are often wrong. So I would usually rather own companies that two out of 10 analysts rate a buy, instead of one where eight out of 10 are bullish. There’s a better chance that if the stock performs well, the bearish analysts will get tired of being left behind and jump on our bandwagon. And when they upgrade the stock, it will only move higher.

However, if eight out of 10 analysts already rate the stock a buy, there’s less of an opportunity to take advantage of an analyst’s change in outlook.

You shouldn’t pick stocks based solely on going against the analysts. You have to have a reason why you believe they’re wrong. But once your opinion on a stock is solidified, don’t let an analyst persuade you out of it. And if you can take the opposite position, that’s even better.

Good investing,

Marc

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Source: Investment U