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. They come into their jobs with the best education money can buy, and they are hardworking and honest.

Nevertheless, because of the way the industry is structured, the folks on Wall Street spend the bulk of their time following the companies where big piles of money have already been made. In other words, they're looking at 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. You might think one way to find the best ones is 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

3-Year
Return

Advanced Micro Devices (NYSE:AMD)

$2.8 billion

30

3

4

18

(74%)

General Electric (NYSE:GE)

$277.0 billion

16

4

3

9

(13%)

Lehman Brothers (NYSE:LEH)

$13.3 billion

18

3

3

11

(63%)

Nokia (NYSE:NOK)

$104.0 billion

21

8

7

6

63%

Walt Disney (NYSE:DIS)

$58.7 billion

28

3

13

10

22%

Data from Yahoo! Finance.

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 "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 AMD?

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

3-Year
Return

Air Methods (NASDAQ:AIRM)

$360 million

4

3

1

0

247%

Graham

$445 million

1

0

0

1

730%

Lufkin

$1.2 billion

2

2

0

0

118%

Twin Disc (NASDAQ:TWIN)

$236 million

0

0

0

0

258%

Data from Yahoo! Finance.

Although 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 probably too busy staffing the 30th analyst to follow AMD'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.

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

Even if an institution loved the prospects of Graham, for example, it 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 market's mega caps.

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 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, having posted 20% average returns (versus 1% for the S&P 500) since 2003. To see our favorite small-cap stock ideas, just click here to sign up for a 30-day free trial.

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. Walt Disney is a Stock Advisor selection. The Motley Fool has a disclosure policy.


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