Investment Consult: Can you trust stock analysts? Not always

November 19, 2001

They provide valuable information, but they sometimes have an agenda that can lead you astray.

 

Investment Consult

Can you trust stock analysts? Not always

They provide valuable information, but they sometimes have an agenda that can lead you astray.

Lewis J. Altfest, PhD, CFA, CFP

You've read high praise for a stock from a top Wall Street analyst. Should you run out and buy some shares? Not unless you know much more about the company than what the analyst has reported. As many investors have learned the hard way, analysts sometimes write glowing reviews of stocks that are headed straight for the basement. Almost never will they warn you to sell a clunker.

Let me say up front that the vast majority of securities analysts are bright, professional people and that I respect what they do. In fact, I myself was an analyst with a major Wall Street firm for many years earlier in my career. They have their place, but there are plenty of reasons to be skeptical about their advice.

One problem—which Congress has recently been investigating—is that analysts rate firms that their employers want to attract or retain as investment banking clients. An analyst's compensation and future can depend on his relationships with such clients, which can be hurt by negative or even neutral reports.

The Securities Industry Association recently released a set of voluntary guidelines for analysts, including a prohibition on linking their compensation to investment banking deals. Still, can you really expect analysts to be objective when their firms stand to benefit from enthusiastic reports?

Even corporations that aren't clients or potential clients of an analyst's firm will apply pressure to get the positive reports they want. And if an analyst doesn't deliver, he risks being cut off from the flow of information the firm dispenses. Without such information, an analyst has less value to his employer and its customers.

Securities analysts and their companies sometimes even hold positions in the stocks they recommend. I once witnessed an analyst recommend a stock to clients and not 10 minutes later sell shares of the same stock in accounts he managed. I believe he really thought he did nothing wrong. To his firm's credit, it reprimanded him severely.

The potential conflict of interest is particularly serious when an analyst owns shares in a private company that is about to go public. This happens all the time, as venture capitalists often offer analysts pre-IPO stock at a large discount. Once public trading in the stock begins, the analyst has a strong self-interest in supporting it.

How can you protect yourself against being misled by analysts' biased advice? Here are some pointers:

• Remember that most analysts inflate their appraisals by at least one grade. "Strong buy" typically means "buy." "Accumulate," "buy," or "market outperform" means stop buying and simply hold what you've got. If an analyst downgrades a stock from "buy" to "hold," you're looking at a recommendation to sell.

• Be particularly wary of rave reviews. A client once asked me to investigate a company, so I called some analysts. They all recommended the stock wildly. I asked one what could go wrong. He said he couldn't think of anything. I told the client I was skeptical because the analysts were too euphoric. Over the next six months, the stock lost 33 percent.

• Always assess or supplement analysts' appraisals with data from an impartial, high-quality service, such as The Value Line Investment Survey.

• Look for what are sometimes called "consensus recommendation scores," which average the ratings of several analysts. You'll find these scores at www.cnnfn.com and many other financial Web sites. Use them to compare stocks with others, or to rank those within an industry. This way, some stocks will be at the top of the list and some at the bottom.

• Focus less on an analyst's current rating of a stock than on how his rating of it has changed over time. Ask the analyst's brokerage to supply you with back copies of his reports on a company. If you see a decline in earnings projections and a higher stock price, consider selling your shares—even if the analyst is recommending a buy.

• Keep your eyes open for disclosures of analysts' potential conflicts of interest, which more and more firms now provide. You'll often find those disclosures prominently placed on the first or second page of an analyst's report. They'll tell you whether the analyst's firm has an investment banking relationship with the subject company or whether the analyst owns any of its shares. If either situation exists, ignore this analyst's advice.

• Use analysts for what they're best at—analyzing information, not recommending. Often, companies pressure analysts to project earnings conservatively so they can subsequently announce "surprisingly" good results. Still, analysts tend to be more accurate with earnings estimates than with recommendations. That's because those estimates are linked to real numbers on a quarterly basis. If an analyst is routinely off, he'll lose credibility.

Analysts can provide you with a wealth of useful information on industries and companies. It would be a mistake to ignore them. But it would be a bigger mistake to simply take everything they say at face value.

The author, a fee-only financial planner, is president of L.J. Altfest & Co. (www.altfest.com ), a financial and investment advisory firm in New York City. This column appears every other issue. If you have a comment, or a topic you'd like to see covered here, please submit it to Investment Consult, Medical Economics magazine, 5 Paragon Drive, Montvale, NJ 07645-1742. You may also send a fax to 201-722-2688 or e-mail to meinvestment@medec.com.

 

Lewis Altfest. Investment Consult: Can you trust stock analysts? Not always. Medical Economics 2001;22:18.