Analysts Love These Stocks

If you're a stock junkie like I am, you know how powerful one word from a Wall Street analyst is.

When one of the stocks I'm following jumps for seemingly no reason -- no earnings release, no news, no nothing -- it's frequently because of an upgrade or downgrade from one of these analysts.

Just as we care what doctors think on health issues, and what roofers think on shelter issues, we care what Wall Street analysts think on "buy, sell, or hold" issues. And once we know, we act.

So what are analysts' favorite stocks right now? I'm about to get to that. But note this: Buying these stocks could be a big mistake.

Analysts' favorite stocks
If the opinion of one expert is interesting, a bunch of experts agreeing is more so. That's why I stuck to companies that are followed by 30 or more analysts.

Using my industrial-strength software from Capital IQ, I screened for the 10 highest-ranked stocks listed on major U.S. exchanges. Without further ado, here are Wall Street's 10 strongest "buy" ratings: 

Source: Capital IQ, a division of Standard & Poor's.

If I didn't know any better, I'd be tempted to create a portfolio out of these stocks. Why not buy the stocks that have achieved the absolute highest rankings by Wall Street's finest?

I can answer with a single word: incentives.

Michael Lewis, when asked by 60 Minutes why Wall Street didn't see the financial crisis coming, said:

"People see what they're incentivized to see. If you pay someone not to see the truth, they will not see the truth. And Wall Street organized itself so people were paid to see something other than the truth...You have to be very careful how you incentivize people, because they will respond to the incentives."

Just as Wall Street brokers were incented to blindly slice and dice subprime mortgages, Wall Street analysts are incented to warp reality in their "buy, sell, or hold" calls.

Why Wall Street analysts are biased
I've written in detail previously about just how screwy the incentives are, so here's the short version. There are very few cases in which it's in a Wall Street firm's best interests to issue a "sell" call on a company it covers. After all, it's competing with other Wall Street firms to provide that same company with help on secondary equity offerings, debt underwritings, private placements, asset financings, hedging activities, mergers and acquisitions, etc.

Would you hire a service provider that spoke ill of you? Neither would those companies. So if it's in a Wall Street firm's best interest to wear rose-colored glasses, you can be sure its analysts are being incented to wear them, too.

Beware relative rankings
So there's a huge bias toward "buys" vs. "sells." And if you're issuing a "buy" call on a company, you'd better darn well make sure your target price is above the current price. Otherwise, you'd look pretty silly. Hence, the upside you see by comparing the analyst targets with today's lower price is based on a lie.

You may be thinking Wall Street's most beloved stocks still rank relatively higher than the rest, but you can't be certain that the relative rankings aren't influenced by incentives as well. It's akin to trusting a used car salesman who assures you that, "This car is the finest on the lot."

Maybe, maybe not. But either way I'm taking it to my own mechanic.

Don't trust Wall Street
Likewise, you can't blindly trust Wall Street's analysis. If you're going to buy individual stocks, you ultimately have to do your own due diligence.

As a first step, let's revisit the companies Wall Street is so high on, looking at their current multiples on next year's earnings ... and then what those multiples would be if the analysts are correct in their bullish upside estimates.

Source: Yahoo! Finance.

The projected P/Es (on the right-hand side of the table) give you an idea of the multiples you'd have to believe to justify the analysts' bullishness. In other words, if their upside price estimates came true today, those are the multiples the market would be pricing in.

One Wall Street favorite that checks out
To help you on your way, let me share some analysis from our Inside Value newsletter.

Of Wall Street's 10 favorite stocks, the Inside Value analysts currently recommend just one at today's prices -- Wal-Mart. Using a discounted cash flow model, they estimate Wal-Mart's intrinsic value to be $68 per share. They recommend buying below $56. If you'd like to see all their analysis on Wal-Mart as well as their other recommendations, access is yours free for 30 days. Click here to start.

Anand Chokkavelu doesn't own shares of any company mentioned. Coca-Cola and Wal-Mart Stores are Motley Fool Inside Value picks. Activision Blizzard is a Motley Fool Stock Advisor selection. Coca-Cola is a Motley Fool Income Investor choice. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. The Fool owns shares of Activision Blizzard and Coca-Cola. The Fool has a disclosure policy.