Today's Strong Buys

Analyzing companies for potential investment is fun, profitable, and educational. Around here, we enjoy it a great deal, and we take a certain amount of pride in getting things right.

As do those on Wall Street, without question. Some of the best minds on Wall Street are tasked with being thoroughly familiar with industries and valuation techniques, come into their jobs with the best education money can buy, and are hardworking and honest.

Nevertheless, because of the structure of the industry, the bulk of Wall Street's time is spent following the companies where big piles of money have already been made. In other words, yesterday's superstars. Let's look at why that is -- and why it's great news for you.

Wall Street's strong buys today? Very large companies!
There are some great companies out there, and you might think that one way to go about finding the best ones to invest in would be to see who's getting the most "Strong Buy" recommendations from Wall Street. Here's some data to consider:

Company

Market
Cap

Total
Recs

Strong
Buy

Buy

Hold

Three-Year
Return*

Alcoa (NYSE:AA)

$31 billion

15

3

6

6

7.3%

Bear Stearns

$11 billion

16

2

4

10

(3.3%)

Gilead Sciences (NASDAQ:GILD)

$41 billion

33

12

16

5

34.9%

Qualcomm

$70 billion

26

6

14

5

8.1%

Verizon Communications

$104 billion

30

4

9

16

6.7%

Data from Yahoo! Finance. *Annualized.

A couple of things to note: First, Wall Street analysts are not likely to rate a stock a "Sell" or "Strong Sell." I didn't even bother to list those categories because they're virtually ignored. Despite attempted reforms in the industry, ratings are more or less constrained to the choice of "Hold" and degrees of "Buy."

Second, a lot of analysts are covering the same companies -- and these are the same companies that the media covers. I mean, how much incremental insight will the 30th analyst bring to Verizon?

Third, the degree to which companies are likely to attract coverage is determined by their market capitalizations, not their past returns or future expected returns. There's a very good reason for that, as we'll address below.

Moving forward
Now, let's take a look at a second list:

Company

Market
Cap

Total
Recs

Strong
Buy

Buy

Hold

Three-Year
Return*

KMG Chemicals (NASDAQ:KMGB)

$189 million

2

1

1

0

30.4%

LB Foster (NASDAQ:FSTR)

$483 million

1

0

0

1

66.5%

Royal Gold (NASDAQ:RGLD)

$929 million

3

1

1

1

21.2%

Vital Signs (NASDAQ:VITL)

$710 million

5

1

3

1

9.8%

Data from Yahoo! Finance. *Annualized.

While these companies, for the most part, have obviously been doing something right, they haven't managed to attract the attention of Wall Street analysts. Wall Street firms were likely too busy staffing the 26th analyst on Qualcomm's trail.

The point of showing these two tables isn't to demonstrate that Wall Street analysts aren't doing their jobs but to prove that they are. It's just that their jobs might not be what you think they are.

Something that isn't worth doing at all isn't worth doing well
There's a lot of money invested in large-cap stocks (an obvious tautology), and that's why Wall Street so closely follows these companies. Their research is intended to help big institutional clients who have so much money that they can really only invest in big companies without fear of moving the stock price.

Even if an institution loved the prospects of L.B. Foster, for example, it really couldn't buy a sizable chunk of the company without running into reporting problems or moving the stock up by establishing a position.

For Wall Street's biggest firms, it isn't worth analyzing small-cap stocks well -- whatever their future potential may be -- because it isn't worth analyzing them at all. Could Wall Street provide quality and compelling coverage on great small-cap companies? No doubt.

But the folks paying the bills generally want to know what's going on with the mega caps in the market.

Why somebody ought to be rating the best small-cap companies
Issuing a report on most of the companies in the small-cap list above just isn't worth it for Wall Street's firms. But that doesn't mean that these companies are of less worth to you, the individual investor -- unless your investments tend to be made in million-dollar chunks. Small caps actually provide better opportunities.

That's because small-cap stocks historically perform better than large caps, produce more big winners, and tend to be less efficiently priced. All of this makes small caps the perfect place to focus your individual research.

At Motley Fool Hidden Gems, that's all we do, and we're happy to spend our time in a place where we don't have to compete much with the really big money. And we're doing pretty well, posting 29% average returns (versus 9% for the S&P 500) since 2003. Just click here to sign up for your free access.

This article was originally published Oct. 26, 2006. It has been updated.

Bill Barker owns shares of none of the companies mentioned in this article. The Motley Fool has a disclosure policy.


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