Each day, Monday through Friday, I write an end-of-the-session wrap-up on what happened with the S&P 500 in which I highlight the economic data and big stories that moved the market, as well as the three best stocks within the index in terms of performance.
As you might imagine, earnings reports and buyout activity certainly have some bearing on what's moving the nation's largest companies, but you would not believe how common it is for the top-performing stocks to rise because of an analyst upgrade or coverage initiation on a company.
Now, I know what you're probably thinking: It's fun to be on the receiving end of an upgrade when you own that stock, or on the receiving end of a sell rating if you're selling a stock short. While I won't disagree that a short-term pop can make for a good day, the reasoning behind most analyst actions is often lacking. In other words, I would propose that most analyst actions can simply be ignored and shouldn't affect your investment thesis one iota.
The way I see it, there are three reasons analyst ratings are mostly meaningless to our general investing theses.
1. Analyst ratings are reactive, not proactive
One of the biggest problems with analyst ratings is that they're always looking backward, rather than forward. Not all, but a majority of brokerage houses place an incredible amount of emphasis on current-quarter earnings reports (which merely tell us how a company has done over the past three months) to determine their ratings. The problem here is that rarely takes into account the long-term growth-drivers or red flags that a company might present.
Although I could single out any one of a number of brokerages here, I chose Argus Research and its coverage of J.C. Penney (NYSE:JCP) as an example.
It's been pretty clear for a while -- even before Penney's brought in Ron Johnson to try to turn its business around -- that the company was losing ground to its department store foes. Yet Argus maintained and reiterated its buy rating on J.C. Penney in October 2009, February 2011, January 2012, and February 2013, all with the presumption that the retailer would turn things around. As we know all too well, that has not happened, and Argus finally acknowledged this fact by downgrading the company from a buy to a hold rating on Oct. 1. All told, Penney's stock has fallen approximately 80% since each of Argus' buy reiterations and is down another 23% since Argus placed a hold rating on the company earlier this month. That right there shows the problem with being reactive to Penney's struggles, rather than being a proactive investor and sniffing out what's going to happen months and even years down the road.
2. There can be no dissenting opinion
Another major problem with brokerage firms -- and one of the reasons I really enjoy working for The Motley Fool -- is that everyone must share the same opinion on a stock.
Just yesterday, FBR Capital initiated pharmacy-benefits management giant Express Scripts (NASDAQ:ESRX) with a buy rating and a price target of $75. This means that, as of now, no one at FBR can suggest any assessment other than Express Scripts is a "buy." The problem with this rationale is that it completely ignores the potential that Express Scripts isn't a buy and essentially closes off avenues for other FBR researchers to investigate what factors could make the company a sell.
Even though I personally like Express Scripts, even I can be open to finding flaws in its business model. I would note that Express Scripts' ongoing integration issues with Medco Health Solutions and the loss of UnitedHealth Group's scripts business could represent a challenge to its growth of the next couple of years. By understanding both the bull and bear arguments in a stock, which we at The Motley Fool strongly encourage, I'm better able to understand why I like, or don't like, a company. This provides a more encompassing picture than the narrow-minded view often presented by most brokerages.
3. There's no accountability whatsoever
This is one point Motley Fool co-founder David Gardner has made on numerous occasions: There's zero accountability for brokerage firms when assigning a rating to a company.
For this example I turn to Ariad Pharmaceuticals (NASDAQ:ARIA) which has had a miserable month after a 24-month study turned up higher numbers than expected of arterial thrombosis (i.e., blood clots) in patients taking blood cancer drug Iclusig, and following its shelved study that would have greatly expanded Iclusig's uses. Shares are down 80% in just the past two-and-a-half weeks.
Before Ariad updated the status of its pipeline there were 24 brokerages covering the company -- nine with the equivalent of a "strong buy," 11 with a "buy" equivalent rating, and four with a "hold" equivalent. Guess what? All 24 would have lost you money if you had listened to them! In fact, Oppenheimer upgraded Ariad to "outperform" less than two weeks before the stock fell off a cliff. Rather than suffer the indignity of admitting it was wrong, Oppenheimer chose on Oct. 10 to reiterate its outperform rating -- although it knocked its price target down 71% from $24 to $7. By comparison, Ariad has been two-star stock on The Motley Fool CAPS system for months, signaling the potential for underperformance.
What's the punishment for a brokerage that makes a wrong call? Absolutely nothing! The reason is that these brokerage firms aren't accountable to anyone, least of all the individual investor.
We at The Motley Fool, in addition to accepting a variety of opinions on a company, also keep public track records of our calls, both good and bad, so we can be accountable to the individual investor. You can see my CAPScall track record by clicking here, as well as my profile that details each and every stock I own here.
Ultimately, you're accountable for your own retirement, not these brokerage firms, so why should you listen to their stock ratings when they have no vested interest in your performance?
Fool contributor Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
The Motley Fool owns shares of, and recommends Express Scripts. It also recommends UnitedHealth Group. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.