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Wall Street Analysts Are Bad at Stock Picking

It might be shocking but stock picking is not the analyst’s job. Until recently, brokerage firms did not even track the accuracy of their analysts’ opinions. It is just not an important part of the analyst’s job description. Wall Street analysts are supposed to pursue information about the companies and industries they cover, evaluate and gain insight on the future prospect of those companies, assess their investment value, and form opinions on the outlook for their stocks. We are required to assign investment ratings such as “Buy” or “Sell” to indicate a net overall evaluation. And that is where the real issues start to surface. Professional qualifications, incentive compensation, and the main audience—institutional investors—do not stress this function of stock picking.

It is not just opinion upgrades, or Buys, that are unreliable; downgrades, or Sells, are also frequently unavailing. In December 2007, a major brokerage firm lowered its Buy rating on Countrywide Financial, a company in the crosshairs of the subprime mortgage debacle, to Neutral after the price had already plummeted from $40 to $9.80. Another high-profile firm underscored its $110 price objective for Bear Sterns while the shares were trading in the $50s, three days before the stock plummeted to under $3 in a JPMorgan Chase bailout. In May 2008, the high-profile oil analysts at a leading firm forecast the price of oil to reach $200 in the ensuing two years. By September the revised forecast was $148 after the price had sunk to $80, and in October the estimate was cut to $86, always following several steps behind the plummeting oil prices. (Oil had cratered to $40 by December.) There were several Buys on Fannie Mae the day it capitulated to $1 a share. Thank you very little! Such calls are all too typical.

An Institutional Investor magazine survey in the fall of 2008 asked the buyside institutions—mutual funds, banks, pension funds, and hedge funds that buy and sell stocks through the brokerage firms—to indicate the most important attributes they sought in sell-side (brokerage) Street analysts. Of 12 factors ranked in order of priority, stock selection placed dead last. Industry knowledge was the key quality that institutions wanted in analysts.

The best analysts, as ranked in the October 2008 Institutional Investor (II) magazine poll, offered some of the worst recommendations over the past year: A leader in covering brokers and asset managers recommended Bear Sterns in January at $77. Eight weeks later it was selling at $2. The number one—ranked insurance industry analyst reconfirmed his long-standing Buy opinion on AIG in August and retained his favorable view until the federal seizure at $3 a share in mid-September. The top-rated analyst in consumer finance pounded the table, enthusiastically endorsing Fannie Mae and Freddie Mac right up until their government takeover below $1 a share.

When stocks have several Sell recommendations, there is nowhere else for that stock to go but up. When the fourth or fifth Sell opinion is issued on a stock, it is probably ready to recover. Analysts are usually late and are also copycats. For years, The Wall Street Journal published a quarterly dartboard contest. The expert stock selections made by analysts and portfolio managers did no better than those picked randomly. A website featuring a newsletter called the “Paradox Investor” assessed the performance of all Sell- and Hold-rated stocks on the Street for a two-year period ending in the fall of 2003. This portfolio of negatively viewed stocks gained 53.5%, more than 75 percentage points better than the market.

Mutual fund money managers are no great shakes either. In the 2007 Barron’s Roundtable, which brings together 11 leading Street stock experts, only four had more than half of their top choices outperform the market. Daunting. In 2008, some 56% of the 72 total picks outperformed, though only 32% showed a gain in absolute terms, and half of those were currencies, commodities, and other nonstocks. More than one-third of the selections collapsed by at least 50%. Quite a statement on the ability of Wall Street to pick stocks.

If that is not enough proof, Charles Schwab rates stocks A to F. From May 2002 to October 2003, its F-rated names, those deemed to have the poorest prospects, performed the best of any category, ahead 30%. In another survey, The Wall Street Journal reported that Investars.com ranked Street research firms by how each one’s stock picks performed compared to the S&P 500 over a one-year span ending in May 2005. You have probably never heard of four of the top five: Weiss Ratings, Columbine Capital, Ford Equity Research, and Channel Trend. The major brokerage Buy-rated stock results were strewn farther down the list. Pretty much the same pattern held true when performance was evaluated over a four-year term. The Street pushes analysts to emphasize institutional hand-holding and marketing, not research and stock recommendations. No wonder the record stinks.

Insightful research analysis has little bearing on the accuracy of Buy or Sell recommendations. Brokerage analysts are usually good at providing thorough, informative company and industry research. But their investment-rating track record is mediocre. The system encourages this by compensating analysts for profile, status, clout, and industry/company knowledge rather than for their investment opinion accuracy. The extreme influence and impact of analysts can result in great damage when investors are misled. Jack Grubman is the poster boy example here. As a telecommunications analyst with more experience than most of the green Internet analysts, he should have known better than to engage in overt cheerleading of his banking clients. Apparently he did not, as evidenced by his statement in a BusinessWeek quote about his actions: “What used to be conflict is now a synergy.” He shunned his fiduciary duty to be relatively unbiased as an analyst. Grubman’s incestuous investment banking behavior destroyed his research credibility. Several of his top recommendations were advocated almost all the way into Chapter 11—Global Crossing, MCI WorldCom, and others. He is now permanently barred from the business.

Analysts’ compensation, often more than one million dollars annually, is unrelated to the performance of their stock recommendations. A portfolio manager’s investment record can be tracked daily in the mutual fund listings. But analysts are not paid for the accuracy of their stock opinions. Their income depends on institutional client polls, overall eminence and influence, institutional sales and trading evaluations, aid in doing investment banking deals (there is still involvement here), and overall subjective judgment by research management.

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