The Upside of Downgrades

At The Motley Fool, we warn investors about reading too much into Wall Street downgrades. News of a downgrade can send shivers through the market, but Wall Street analysts often get it wrong.

Let me repeat: Analysts get it wrong. I hear this statement so often from Fool writers that I've been taking it as a given. But are analysts really that far off? After all, it's their job to understand the companies they follow.

I decided to investigate and see if I could put some real data behind this assumption.

The numbers don't lie
Take a look at this history of analyst opinions for Intel (NASDAQ:INTC) from CSFB. I've determined that CSFB's bullish ratings (Outperform, Buy, and Strong Buy) were successful if the stock beat the market between the time of the rating and the next upgrade or downgrade. Bearish ratings (Sell and Underperform) are considered successful if the stock underperformed the market in that time, and the Neutral rating is considered successful if the stock performed within 5% of the market return.

Only two out of eight ratings were accurate. Seems silly to worry about analyst opinions now, doesn't it?

CSFB opinions for Intel:

Merrill's report card
Okay, so maybe CSFB got it a wrong a few times. Other analysts might have done better. Let's check in on the venerable Merrill Lynch.

Merrill Lynch opinions for Intel:

Merrill Lynch's pronouncements are a little more confusing, because it gives near-term (NT) and long-term (LT) ratings. But we can decipher which ratings are meant to be bullish (Accumulate and Buy) and which are meant to be bearish (Sell).

Over a roughly seven-year period, Merrill Lynch analysts made the correct call three times out of 11. That's a 27% success rate! If you had made buy and sell decisions for Intel based on analyst recommendations, your performance would have been dismal.

This is a small sampling of analyst opinions, but it should give you some idea of what to expect the next time your stock is downgraded. Stocks recently in Wall Street's doghouse include Digital Insight (NASDAQ:DGIN), Gap (NYSE:GPS), and Intralase (NASDAQ:ILSE).

What went wrong?
Why do analysts have such a low success rate? First and foremost, Wall Street has a very short-term outlook. I don't care how good an analyst is -- predicting price movements over a one-year period is difficult. If you truly feel a stock is a good value, it may take three years or more for the market to come to the same conclusion.

Second, analysts may have conflicting interests that could influence their opinions. Analysts may inflate their ratings in hopes of driving lucrative investment banking business to their firms. In 2002, Merrill Lynch and other firms were fined by the Securities and Exchange Commission (SEC) for this very practice.

Foolish bottom line
The next time your favorite stock falls on a downgrade, view it as a potential buying opportunity. Has the fundamental business changed in any material way? If not, you may be able to pick up the stock on the cheap (after doing some careful due diligence, of course).

For further Foolishness:

• 5 Stocks That Could Slaughter the Market
• Stocks With Growth Engines

Intel and Gap are Inside Value recommendations. Value guru Philip Durell loves stocks that are in Wall Street's doghouse. Find out how he's beating the market by taking a free trial. Gap is also a Stock Advisor selection.

This article was originally published on Feb. 6, 2006. It has been updated. Fool sector editor Joey Khattab does not own shares in any of the companies mentioned. The Motley Fool has a disclosure policy.