Wall Street Is Still Cheating You

Stimulus, schmimulus. Wall Street can't be fixed the way it is, President Obama. The system needs a total overhaul.

The bankers aren't the only ones to blame. Sure, hundreds of them should be in jail -- they cost us billions by taking on more leverage than they could afford, and by betting on sure losers like credit default swaps on U.S. government bonds.

Those moves were hubristic. Moronic. And directly linked to the economic conditions that now argue for hundreds of billions in stimulus. Thanks for that, guys. Thanks a lot.

But even if we jail the bankers, we're left with the analysts: Harvard-trained number crunchers who treat stocks as if they were part of some sort of flavor-of-the-month club. They'll cheat you out of a fortune if you let them.

How to give away a fortune
You see, analysts abide by a specific vernacular that begins and ends in 12-month price targets. That's by design; big brokers serve big clients, and big clients -- institutional investors such as mutual and hedge fund managers -- move money into and out of stocks as fast as a hyperactive 2-year-old on a sugar high. These traders need to know the flavor of the month, the day, the hour, the minute.

Some even profit from the process. Ken Heebner of the CGM Focus (CGMFX) fund, whose current holdings include Apollo Group (Nasdaq: APOL  ) and MetLife (NYSE: MET  ) , swaps out the contents of his entire portfolio at least three times annually. Yet he's still produced a full decade of 16.7% average annual returns, crushing the S&P.

So why not trade as Heebner does? Two reasons:

  1. There's only one Ken Heebner.
  2. You aren't him.

Actually, there's also a third reason. Heebner almost never gets his ideas from the Street. "I'm not waiting for Morgan Stanley to tell me there's something wrong in China," Heebner told Fortune in a May 2008 interview. "By then it's too late."

Heebner, in other words, is proof of the folly of following the Street's upgrades and downgrades. Here's more: Green Mountain Coffee Roasters, one of the market's 10 best stocks of the past decade, has been downgraded to something less than "buy" six times.

The first downgrade, by Adams Harkness on Oct. 25, 2002, took Green Mountain from "buy" to "market perform." But of course, it didn't -- Green Mountain was built to outperform. From then till now, the stock has been a 10-bagger, versus a 6% gain for the market-tracking S&P 500 SPDR.

Interestingly, Green Mountain earned roughly 43% of that gain between Oct. 25, 2002 and Oct. 24, 2003 -- the one-year period in which analysts operate. And how did the SPDR do? Up 16.7%, it turns out. That's two strikes, Adams Harkness.

But let's not pick on a single analyst. Or cherry-pick dates, for that matter. There's no reason to; the data shows that upgrades and downgrades don't matter nearly as much as the headlines suggest. Every one of these winners was downgraded to something less than "buy" at least once during its five-year run:

Company

5-Year Return

Downgrades (Since April 04)

Upgrades (Since April 04)

Illumina (Nasdaq: ILMN  )

809.7%

7

15

Walter Industries (NYSE: WLT  )

275.8%

3

6

Immucor (Nasdaq: BLUD  )

241.4%

3

5

Sources: Capital IQ, Yahoo! Finance.

Following the Street's gyrations might have earned you profits in these stocks, but it might also have cost you fantastic returns. With the S&P down roughly 19% over the same period, you'd almost certainly have done better buying after the first downgrade and holding for as long as the underlying business supported your thesis for investing.

Stimulate your portfolio
If this process sounds familiar, it should. Fool co-founder David Gardner sustained a decade of 20% returns in the real-money Rule Breaker portfolio by zigging when the Street and major financial press screamed "zag!" His contrarian investing style echoes Heebner, who told Fortune that he's most comfortable as an investor "when everyone else thinks I'm nuts."

The beauty of David's rebellious style of investing is that you'll rarely be short of ideas; upgrades and downgrades occur daily. Briefing.com found 31 downgrades on Thursday, including Men's Wearhouse (NYSE: MW  ) and VMware (NYSE: VMW  ) .

My favorite idea right now is a current pick of David's for Motley Fool Rule Breakers; in January, this stock was downgraded three times. Crazy. Not only is this business the undisputed leader in an emerging sector of the health-care market, but the stock has also more than doubled since David first picked it for the April 2005 issue. Yet analysts say now -- right as this well-heeled cash gusher is trading well below its 52-week high -- is the time to sell. Color me thrilled.

Intrigued? Click here to try Rule Breakers free for 30 days -- you'll get the name of that stock, as well as our team's five top growth stocks for new money now.

This article was originally published on Feb. 21, 2009. It has been updated.

Fool.com contributor and Rule Breakers analyst Tim Beyers didn't own shares in any of the companies mentioned in this article at the time of publication. Green Mountain Coffee and VMware are Rule Breakers recommendations. Illumina is a Stock Advisor selection. CGM Focus is a Champion Funds pick. The Motley Fool's disclosure policy caught a rival disclosure policy cheating at cards last year. That policy hasn't been heard from since.


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