Imagine you're buying a house. You're driving around with the realtor, who shows you what looks like a very nice option. It has all the features you want -- the pool, the granite countertops, what have you -- and the realtor keeps telling you that it's worth "so much more" than what you'd be paying. You start to think, "Maybe this house is a pretty great deal!"
But what if you found out that the owner of the house could directly influence the realtor's career? Would you still buy it?
As it turns out, the financial industry sometimes works in the same way, and it's yet another reason you shouldn't listen to stock analysts.
Hedge funds and analysts
Looking at a database of 19,000 hedge funds and their ownership in public firms between 1999 and 2012, a recent working paper written by three business school professors found that the more hedge fund ownership a stock had, the more optimistic analysts' price forecasts for it were.
Looking at American companies and hedge funds, the paper concluded that hedge fund ownership one standard deviation above the average is associated with a 23% rise in optimism about prices.
The researchers theorize that this happens largely because hedge funds can directly influence analysts' careers. How? Through votes: Most brokers use client votes on analyst performance to determine things like bonuses and career paths. As it happens, a lot of votes are controlled or influenced by hedge funds.
At the same time, more optimistic forecasts mean better trading results for the funds. In other words, the two parties have every reason to please each other, even if they aren't doing it openly.
What do I do with this information?
This is a good reminder that analyst forecasts should be taken with a grain of salt -- especially if there's a large amount of hedge fund ownership involved.
What's most important is that you do your own homework. The best approach to stock picking is to analyze a company's fundamentals, gaining an understanding of its strategy, market, and competition. In other words, rather than relying on biased analysts, come to your own conclusions by investigating the companies you're interested in and evaluating their profitability and future prospects.
When you do your own research, it doesn't matter what the analysts say and whether it is biased by their career concerns or not; you won't be listening.