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 lovestruck 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 companies.
And then what happened?
(NYSE:GLW): Down 85%.
(NASDAQ:CMGI): Down 99%.
(NASDAQ:CIEN): Down 99%.
Things change, yet remain the same
After the bubble went pop, 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.
From 2000 to 2004, stocks that the Street had been telling you to sell increased, on average, 19% annually. Meanwhile, the "buys" and "holds" increased 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, just because a sell-side analyst believes a stock is a dud, that doesn't necessarily mean he's going to 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 their own reservations -- heck, they might have had a 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 -- and buy it right now.
Of course, if an analyst's personal (and often private) belief that the company is doomed turns out to be right, there's plenty of time to make a second commission. He'd just opine that the circumstances have changed, and it's time to sell that stock. You know, the one he told you to buy three months earlier.
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 the fact that they are (not to put too fine a point on it) a bunch of desk-bound, paycheck-driven bureaucrats. There. How'd I do?
Try to look at life from the other side of the analyst's desk for a moment and you'll see what I mean. Let's say that seven years ago, an analyst had to make a decision between recommending perennial tech favorite Sun Microsystems
At the time, few people suspected that the next five years would see Sun lose most of its entire market cap while American Standard more than tripled in value. And of those analysts who did see the potential for riches in kitchens, few were willing to bet their jobs on it.
So why wouldn't they? Let's turn for a moment to Peter Lynch, legendary investor and former head of the Fidelity Magellan (FMAGX) fund. He summed up Wall Street analysts' thinking on questions such as the Sun/Standard dilemma by saying, "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 American Standard ... 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 -- begging for your job.
Now contrast that with what happens when an analyst puts a "buy" recommendation on a stock such as Apple. Apple currently sports 23 "buys" and four "holds," but not a single "sell." 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. Apple really made a mess of things," they'll say.
See the change in emphasis? If an analyst's right in a crowd, he's just right. But if he's wrong in a crowd, the analyst -- and everyone else who was wrong along with him -- claims no responsibility. I can hear the chants now: "We didn't do anything wrong. The company screwed up."
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 -- he's safe.
Be the cowboy, not the cow
As an individual investor, you don't have to be part of the herd. Like a cowboy circling on the outside, you can watch as the cows collectively shamble to and fro, yet are indeed moving independently. 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, you can wait until they're gone and examine what they've left behind. It could be ripe for the picking.
Keep in mind that any pasture the analyst herd is eager to leave is probably laden with certain -- well, let's call them land mines. So watch where you're stepping as you go a-grazing. That's where the research team at the Motley Fool Inside Value newsletter service can help. The team is adept at navigating the endless fields of abandoned stocks, locating and avoiding the land mines, and wrangling tasty treats along the way. One such treat, Inside Value recommendation Coca-Cola, has the strongest brand in the world and currently sells at a nice discount to its intrinsic value.
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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. The value of The Motley Fool's disclosure policy is a definite "buy."