Analyst ratings are a seductive concept: Security analysts who spend their days researching and speaking to companies provide investment recommendations, neatly packaged in a single action word: buy, sell, or hold. If only investing were that simple! In fact, there are numerous reasons why individual investors should ignore Wall Street analysts' ratings. Here are three.
Jordan Wathen: Wall Street analysts don't work for you. In a study by the University of Texas, some 81.5% of stock analysts who were polled said hedge funds were their most important clients. Only a fraction cited retail brokerage clients -- people like you and I.
Most important, nearly 40% of analysts polled said they believed they would be left out of discussions with company management if they issued earnings forecasts below the Wall Street average, and more than two-thirds said they believed private phone calls with management were the most important factor in their jobs. Thus, the job of the sell-side analyst is more about remaining friendly with management than it is about accuracy. Staying on good terms with management teams allows them to be the liaison through which hedge funds and other major investors can speak to corporate executives.
In addition, most analysts work for banks, which have an incentive to encourage investors to buy a company's stock. Investment banks earn billions of dollars by underwriting stock sales to the public. Banks with sell ratings will likely lose these lucrative assignments to banks with buy or strong buy ratings.
Given all these factors, I think it's smart to largely ignore analysts, as they have every incentive to avoid bringing to light the downside of any stock, which is why there are so few sell ratings -- probably the only truly honest ratings on Wall Street.
Alex Dumortier: What is your investing time horizon? If you're a day trader, you can't afford to ignore analyst ratings -- upgrades and downgrades can create significant daily stock price moves. If you're a genuine investor, with an investor's time horizon (five years, at a minimum), you're better off ignoring analysts' ratings on the basis of a mismatch in time horizon.
As my Foolish colleague Jordan pointed out above, Wall Street analysts don't cater to individual investors, but rather to the professional investor community, particularly hedge funds and mutual funds. These investors have relatively short time horizons -- it's not unusual for a mutual fund to turn over its entire portfolio every year, and many hedge funds are even more frenetic in their approach to stock ownership. As a result, in publishing their recommendations, analyst are making calls with a time horizon of roughly six to 18 months.
Except for special situations in which there is a clearly identifiable catalyst, predicting stock price performance over such intervals is very difficult (if not impossible) and is a distraction from the game in which individual investors have the greatest odds of success: identifying superior companies that are likely to compound value over extended periods of time. Read analysts' reports, by all means -- they often do excellent company and industry research -- but please, please ignore their stock ratings; they're unlikely to help you improve your investing results.
Dan Caplinger: One important reason not to give too much weight to analyst ratings and earnings estimates is that they inherently rely on information that those analysts get from the companies themselves. Some companies appear to use that relationship in order to keep expectations artificially low and then produce repeated earnings beats that would presumably result in rising share prices.
Indeed, the American Association of Individual Investors studied this issue and noted that most companies consistently beat their estimates. The AAII directly attributed the phenomenon to companies that "are careful to set expectations in their public statements during the quarter that are just slightly below what they know they will be able to deliver." At the same time, the AAII noted that analysts also don't want to stick their necks out, encouraging them to stay close to each other's estimates and making it easier for companies to manage earnings and produce expectation-beating results.
It's easy to get caught up in the earnings-beat game, and enough investors still pay attention to such things that share prices often move following earnings announcements. Nevertheless, focusing too much on analyst views can distract you from your own analysis of a stock -- which is often much better suited for long-term investing decisions.