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Analysts Running Scared

By now, it should be news to no one that Wall Street analysts were hopeless romantics in the 1990s. Smitten with tech-stock love, they fell head over heels for unrealistic growth expectations, "eyeball"-based business models, and all things dot-com.

When the bubble burst in early 2000, these love-struck analysts were caught with their analytical pants down. As tech stocks plunged from stratosphere to lithosphere, a whopping 95% of all equity issues then trading on the public markets were totally free of any "sell" ratings. What's more, according to investment research firm Zacks, the 5% of stocks that did have a sell rating had exactly that: one sell rating. Every analyst in the country, with the exception of a single lone crank, refused to cast doubt on these most doubtfully priced of companies.

And then what happened?

  • Broadcom (Nasdaq: BRCM  ) : down 95%.
  • Nortel Networks: down 99%.

While both stocks have since recovered a bit, the carnage was widespread.

Things change, yet remain the same
After the bubble popped, a new trend emerged. Stock analysts began to reverse themselves, advising investors to sell what was left of their stocks.

And so the stocks began to rise.

In fact, from 2000 to 2004, stocks that the Street told you to sell rose 19% per year, on average. Meanwhile, the "buys" and "holds" rose just 7%.

So is Wall Street just stupid?
No. On the contrary, the analysts working on the Street are bright guys and gals -- but that doesn't necessarily work to your advantage.

You see, even if a sell-side analyst believes a stock is a dud, he won't necessarily clue you in. Think back to that 2002 TV ad where the pinstriped broker tells his analyst: "Let's put some lipstick on this pig!" That's how the game was played pre-millennium. Analysts might have had private reservations -- heck, they might have had a private case of the giggles -- about the prospects for a stock. But that certainly didn't mean they were going to rate it a "sell."

Remember, these people have commissions to earn. And they don't make commissions by telling people who don't own a stock that they shouldn't own it. They make commissions by telling people who don't own a stock that they need to buy it right now.

And of course, if their private belief that the company is doomed turns out to be right, there's plenty of time down the road to make a second commission by opining that the circumstances have now changed, and it's time to sell that stock they told you to buy three months ago.

Gurus gone mild
But the desire to make sales and earn commissions is only half the story. The other reason that Wall Street analysts tend to make bad calls in public -- even when they're right in private -- is that they are (not to put too fine a point on it) a bunch of desk-bound, paycheck-driven bureaucrats.

Try to look at life from the other side of the analyst's desk for a moment, and you'll see what I'm getting at. Let's say that in 2000, an analyst had to make a decision between recommending "power-of-the-future" researcher Plug Power (Nasdaq: PLUG  ) or money-mover and former Inside Value pick First Data, which had gained barely a penny in value over the past four years. Its now-divested Western Union (NYSE: WU  ) brand might have been world-famous and well respected, but First Data itself got little respect on Wall Street.

At the time, few people suspected that the next five years would see Plug lose 85% of its market cap, while First Data more than doubled in value -- and was eventually acquired by KKR. Among those analysts who did see the value in First Data's mundane money-moving services, few wanted to bet their jobs on the company outperforming the market.

Herd mentality
To see why that's so, let's turn for a moment to legendary investor and former Fidelity Magellan fund head Peter Lynch. He summed up Wall Street analysts' thinking on questions such as the Plug Power-First Data dilemma thusly: "Success is one thing, but it's more important not to look bad if you fail."

Sure, an analyst could have made his clients a lot of money by seeing the value inside First Data, the potential for outsized returns just waiting to be unlocked. But what if the analyst was wrong? When all of your colleagues are pointing out a company's problems, do you go out on a limb and say: "I beg to differ"? Probably not. Because if you're wrong, you'll be begging for your job.

Now contrast that with what happens when an analyst puts a "buy" recommendation on a stock such as XM Satellite Radio, which continues to lose money. In the current month, analysts still have 13 "buy" ratings on the stock, 12 "holds," and not a single "sell." Now, if everyone is sure that a stock will go up, and it does, it's all good. On the other hand, if the stock somehow tanks, everyone just gasps in mock amazement: "Wow. XM really made a mess of things."

Thus, analysts have learned that there's safety in numbers. The cow that wanders from the herd gets eaten by wolves (or thrown to them by an irate mutual fund manager). But as long as the analyst sticks with the rest of the cattle, it doesn't much matter whether the herd's moving in the right direction or the wrong -- the analyst's job is safe.

Be the cowboy, not the cow
As an individual investor, however, you don't have to be part of the herd. Like a cowboy circling on the outside, you can watch as the cows shamble to and fro -- yet still move independently yourself. When the analysts are all chanting "buy, buy" and charging toward a cliff, you can just step out of the way. And when they're bellowing "sell, sell" and rushing off to greener pastures on the other side of some fence, you can wait until they're gone and examine what they're leaving behind. Could be that you'll find it right tasty.

Now, mind you, any pasture that the analyst herd is so eager to leave is probably laden with certain, er, land mines. So you do want to watch your step as you go a-grazing. That's where our research team at the Motley Fool Inside Value newsletter service can help. They're adept at picking their way through well-used fields of abandoned stocks, locating and avoiding the land mines, and finding tasty treats such as Inside Value pick First American (NYSE: FAF  ) . This is a company with excellent management and long-term competitive advantages, thanks to its growing databases, and it currently sells at a discount to its intrinsic value.

For a peek at the other treasures Inside Value has already turned up, be our guest free for one month.

This article was originally published on April 28, 2005. It has been updated.

Fool contributor Rich Smith has no financial position in any of the companies mentioned in this article. Western Union is an Inside Value recommendation. The Motley Fool's disclosure policy is a definite "buy."

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