The Problem Behind Wall Street's Screaming Buys

In early March, Bespoke Investment Group published a list of the 23 tickers that Wall Street analysts covet most. It's a truly fascinating list, but not for the reasons you might expect.

Analysts rate the stocks on this list a buy roughly 80% to 90% of the time and offer up few, if any, sell ratings. These are effectively Wall Street's pound-the-table, screaming buys.

But there's something you should know about these alleged best-of-breed stocks, because this secret exposes one of Wall Street's most fundamental shortcomings.

The hot list
To figure out the secret, we first have to look at who's on the list in the first place.

Apple (Nasdaq: AAPL), Bank of America (NYSE: BAC), and JPMorgan Chase (NYSE: JPM) are the three largest businesses by market cap -- and those are pretty big. For your viewing pleasure, here are a few more (in no particular order) that made the cut:

But which companies are on the list is not nearly as important as what types of companies are on this list.

The message within
There's a fair bit of variety in the industries represented. There are also both familiar and unfamiliar names on the list. You don't find nearly enough international businesses here, but that's not really what interests me about this list.

No, what interests me is this: The companies on this list, by and large, are both large and valued richly.

Mean and median market caps are $57 billion and $28 billion respectively, with the biggest among them pushing a $242 billion valuation and the smallest $3 billion.

From a valuation perspective, the bias is even more telling. The mean and median P/E ratio of this hot list is about 23, with a high of 46 and a low of 12. The average S&P 500 stock has a multiple of 17.

Of course, we all know that Apple has been on a tremendous tear for quite a while. It's got the love of Main Street and Wall Street both, and so its appearance on this list is no big shock. Halliburton is, of course, interesting not because we always love a good oil/energy name, but because of its recent involvement in the BP oil spill in Louisiana. I'll be very curious to see whether it continues to appear on this list, especially considering what liability it might bear for the disaster.

Express Scripts and Life Technologies are two quickly growing names in the larger health-care field that have been on fire over the past year, both supporting rich valuations and strong price momentum. On their own, each of these names and their appearance on this list is fascinating. All put together, however, these companies represent a much larger trend on Wall Street.

What this list helps show us is that Wall Street loves the combination of a rich valuation and a massive capitalization. You'll soon discover that this is somewhat to be expected -- but it's a problem for us individual investors.

Why it's a problem
Jeremy Siegel discovered in Stocks for the Long Run that between 1957 and 2006, low P/E stocks beat high P/E stocks by 5.4 percentage points per year. Dozens of studies have echoed this same conclusion.

A similar incongruence appears when you examine the size of these companies. Ibbotson Associates studied data from 1927 until 1997 and concluded that small-cap stocks beat their larger counterparts by 4.3 percentage points per year. Vanguard and two famous academics, Eugene Fama and Kenneth French, each conducted similar studies and each gathered similar conclusions: When it comes to stocks, smaller is generally better.

In other words, Wall Street's screaming buys aren't likely to lead to a fabulous portfolio. If studies show that smaller and cheaper is better, then what's really going on with Wall Street calls?

Wall Street research explained
Wall Street research firms, like every other company around, are in business to make money. They don't generally cover smaller stocks, even if those smaller stocks are, in fact, better, because the firms simply don't make enough money doing it. Their customers are primarily institutional investors, and those big mutual funds can't buy small companies. Hence, little research and few recommendations.

This problem is fairly understandable. The other problem is a bit less forgivable.

Wall Street research firms aren't really in the business of developing and selling quality, marketing-beating research. The majority of firms on the Street use their research divisions to "support" much larger, much more profitable divisions within the company, including investment banking, mergers and acquisitions, proprietary trading, and high-net worth asset management divisions. Over time these intra-office and inter-corporation relationships develop and multiply, which seriously undermines the quality of research manufactured on the Street.

Analysts often find it difficult to call the game as they see it. Compound this problem over many thousands of companies and many wishful banking departments and the natural result is that "buy" ratings flow much more freely than they should. Objectivity tends to take a backseat to the needs of the larger business.

In other words, when Wall Street issues "buy" calls, it isn't always issuing them to help you.

The Foolish bottom line
Instead of looking for Wall Street's screaming buys, consider looking for their opposite: small, cheaply valued companies that the Street tends to ignore.

It's no surprise that plenty of great investors have adopted small-cap, value investing philosophies into their larger repertoire. It's a greener, more lucrative, less populated playground precisely because the big guys (and the people who hang off the big guys) don't want to do it. In this area, you'll typically find more opportunities for great risk-adjusted returns and you'll typically have more time to explore them, because the opportunity doesn't disappear as fast.

This strategy requires avoiding Wall Street's calls at all costs and doing your own research into the quality and the valuation of small companies. That's exactly what our Motley Fool Hidden Gems investment service does, which I use to get ideas. If you'd like to see which small companies it's recommending today, take a free 30-day trial by clicking here. There's no obligation to subscribe.

Fool Nick Kapur owns no shares in any company mentioned above. Apple is a Motley Fool Stock Advisor recommendation. The Fool has a disclosure policy.