Analysts Are Wrong About This Stock

I am going to tell you about a stock that analysts are completely wrong about.

Before I reveal it, though, let me set the stage with a cautionary Wall Street tale. I warn you, it may make you angry.

As reported by The Wall Street Journal, Brian Kennedy is a Wall Street analyst who nailed a "sell" call last April. He saw bad things ahead for CardioNet -- the maker of a wireless heart-monitoring system. Specifically, based on his research, he expected Medicare to heavily reduce the price it paid for CardioNet's system.

He was spot-on. Less than three months later, Medicare made its price cut, and CardioNet shares plummeted. Kennedy's warning in April saved his followers a 70% loss ... during a bull rally, no less.

His call looks great now, but at the time, all he got was:

• Ridicule from competing analysts
• Hostility from co-workers
• An internal legal investigation
• An SEC complaint (filed by CardioNet)

He would enjoy being proven right and getting the last laugh, except for one thing. Realizing that "there is no real desire for that kind of report on Wall Street," he quit his job at Jefferies & Co. in July.

The why behind the why
You would think that a guy who could think independently to save his clients a fortune would be exactly the type of guy you'd want to keep around.

I know I would want him around. I know my colleagues at The Motley Fool would as well. And I'm sure you would, too.

But Wall Street? Not so much.

Yes, they want to please their clients. But not at the expense of ticking off other, more lucrative clients.

You see, Wall Street firms don't just make "buy, sell, or hold" calls on companies. They also underwrite the IPOs and secondary offerings of these very same companies. This is in addition to debt underwriting, mergers and acquisitions advising, and anything else they can charge for.

Sure, "Chinese walls" and other precautions help, but it's simply not in Wall Street's best interest to criticize a client.

Now, this wouldn't be quite as big a deal if Wall Street wasn't so incestuous. When a company goes looking for capital, it's not just one firm that helps it out. Nope, Wall Street forms a syndicate. When Google went public in 2004, 28 Wall Street firms underwrote the IPO, including Morgan Stanley, Goldman Sachs, JPMorgan Chase, and on down the list. When Visa went public in 2008, 45 underwriters were on board.

Because the gravy train only starts with a company's IPO, you can see how there are incentives to rate a company a "buy" or at the very least a "hold." And don't be fooled. Companies know who's been naughty and who's been nice. You can go back to CardioNet's complaint filed with the Securities and Exchange Commission against our intrepid analyst for proof of that.

Here's how bad it is
Recent data from Thomson Financial gives us an idea of just how blatant that "buy" rating bias is: Analyst buy calls outnumber "sell" calls almost 7 to 1.

For a more ground-level feel, let's take a look at the company-by-company level. Here are consensus ratings for the 10 largest S&P 500 stocks starting with the letter P:

Source: Capital IQ, a division of Standard & Poor's.

I could nitpick here and there, but I can't quibble too much with many of the bulk of these specific buy calls. Procter & Gamble and PepsiCo are the kinds of solid, easy-to-run companies I'd gladly buy on weakness. And heck, I own shares of Philip Morris International and Pfizer. In fact, I'd agree with Wall Street that Philip Morris International is a buy at today's prices.

No, my beef isn't with the disproportionate buy calls on just these 10 "P"s. It's when you go through the entire S&P 500 that I grow skeptical: When I did this, I noticed that there are only two companies that are so bad that they are consensus "sells" (Sears Holdings and Kodak, if you're curious).

Analysts are wrong about this stock
Believe it or not, Hershey was rated a "sell" until fairly recently; it has now made its way up to a "hold." Yes, you can criticize Hershey for being closely held, for stagnating growth, and even for being a bit pricey (as if to prove my point, it's currently trading significantly higher than when it was a "sell").

But the fact remains that Hershey has a 40% share of the stable U.S. chocolate market, is pumping out cash flows that are much higher than earnings, has a strong balance sheet, and has a sustainable 2.7% dividend.

In short, it's utterly ridiculous that Wall Street had singled out Hershey as one of the very worst bets out of the entire S&P 500.

It's thinking like this that gets me fired up to research stocks and take on the market. It's also what spurred David and Tom Gardner to start The Motley Fool in the '90s. In March 2002, they took it a step further by starting their Stock Advisor investing service.

Each month since then, David and Tom have each picked one stock they consider a "buy" and have combined to beat the market by an average of 56 percentage points per recommendation. If you'd like to join them and see all their picks, click here for a free 30-day trial. You can cancel at any time.

This article was originally published Jan. 23, 2010. It has been updated.

Anand Chokkavelu owns shares of Philip Morris International and Pfizer and has been thinking about a KitKat bar since the first mention of Hershey. Pfizer is a Motley Fool Inside Value recommendation, Google is a Rule Breakers choice, and  Precision Castparts is a Stock Advisor pick. Philip Morris International is a Global Gains recommendation. Procter & Gamble is an Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on PepsiCo. The Fool owns shares of Procter & Gamble. The Fool has a disclosure policy.