Chances are, as an investor, a stock you've owned has gained at some point as a result of a Wall Street analyst's "buy" or "strong buy" rating, accompanied by a price target considerably higher than where it was currently trading. I know I have.
However, the truth of the matter is that Wall Street analysts' stock ratings probably aren't worth paying too much attention to if you're a long-term investor. There are five specific reasons why you should view Wall Street analyst ratings with a strong degree of skepticism.
1. There's no accountability to individual investors
Arguably the biggest issue with Wall Street analysts is that there's no accountability if they wind up being horribly wrong.
For example, drugmaker Valeant Pharmaceuticals (NYSE:BHC) has seen its share price fall by nearly 90% since August 2015. The company revised its profit projections lower for the year twice, delaying both its 2015 annual filing and first quarter 2016 filing due to incorrect revenue recognition tied to a former drug distributor, and experienced multiple probes into its business and pricing practices. The company is also figuring out how to reduce its $30.8 billion in debt, since its access to new capital has essentially been cut off by its lenders.
Despite these woes, as recently as November 2015 Valeant's consensus price target was $188.41. Its share price has fallen around 85% from this level, crushing any investors who purchased Valeant solely based on Wall Street's lofty price targets. Meanwhile, Wall Street analysts have continued their coverage of Valeant, lowering their ratings and/or price targets many times over, and they're not necessarily worse for the wear.
Wall Street analysts simply aren't accountable to the individual investor.
2. Ratings are often made on a reactive basis
Secondly, long-term investors should understand that just because Wall Street analysts are put on a pedestal for their perceived industry knowledge, the vast majority of their ratings are reactive to company events, such as quarterly earnings reports, and not proactive to account for perceived industry trends.
For instance, 10 Wall Street firms cut their rating on professional social networking company LinkedIn (NYSE:LNKD.DL) the day after it reported its fourth-quarter results in February. In that report, LinkedIn topped both Wall Street's sales and profit projections for the quarter, but guided its first-quarter expectations to $820 million in revenue and $0.55 in adjusted EPS versus a consensus on the Street of $868 million in revenue and $0.75 in adjusted EPS.
Was the company's business model broken after one slightly subpar forecast? Clearly not, but that didn't stop a reactive group of Wall Street analysts from piling on the bearish bandwagon.
Ironically, LinkedIn wound up announcing an acquisition by Microsoft in June for $196 a share, or close to double where it was trading the day it received 10 downgrades from a single earnings report.
This is just another reason why individual investors have to decide for themselves whether a business has simply hit a speed bump, or if its entire model is broken or changing.
3. There are rarely dissenting opinions
A third reason to be skeptical of Wall Street's analyst ratings is that there are rarely, if ever, dissenting opinions among employees of a brokerage firm. In other words, if a brokerage firm comes out with a "buy" rating on a stock, then that becomes the official position of that firm, no questions asked. Having a unified rating on a company could bias a brokerage firm to see only what it wants to see to confirm its initial analysis, while discouraging other members of the firm from digging into potential pitfalls of that thesis.
On the other hand, we at The Motley Fool believe in supporting a diverse array of insights, because we believe it'll make us better investors over the long haul if we understand both the buy and sell rationale for every stock we own and/or are considering buying.
4. Price targets are often based on short-term goals
Fourth, in addition to probably being far more reactive to news events than they should be, Wall Street analysts also have a tendency to place a lot of emphasis on the short-term in their ratings and price targets. Why? Frankly, it's because predicting the next move up or down in the market over the short-term is what they're paid to do.
One of the more memorable recent examples comes courtesy of hair salon chain Regis (NYSE:RGS) and Piper Jaffray analyst Stephanie Wissink. On May 19, Wissink downgraded Regis to "underweight" from "neutral" and slashed its price target to $8 from $13 following an overtime rule change from the U.S. Department of Labor that Wissink anticipated would increase Regis' costs by $81 million. Wissink found out just hours after the downgrade that most of Regis' managers weren't salaried and were already claiming overtime hours, prompting an upgrade back to "neutral" and a new price target of $12 all within the same day. The added costs of $5 million are menial next to the $1.84 billion in sales Regis brought in last year in sales, yet it prompted a swift short-term pricing reaction, and two rating changes, from Wissink.
5. Analysts may have conflicts of interest
Finally, Wall Street analysts can sometimes have personal conflicts or biases that should make you skeptical of their ratings and price targets. Some firms disallow their employees from owning stocks that they cover, but that doesn't necessarily mean those analysts can't recommend those stocks to family members or close friends.
Likewise, Wall Street brokerage firms tends to have what could be referred to as "buy bias." "Buy" ratings far outnumber "sell" ratings for what I believe to be one simple reason: a "sell" rating is a red flag that could destroy any chance a brokerage firm has of getting business from the companies they're covering. In some cases, the same brokerage firms that are bringing IPOs to market, working out new financing terms for a company, or helping to evaluate strategic alternatives for a business are offering a rating and price target. This potential conflict of interest can't be ignored by long-term investors.
Ultimately, you're accountable for your investing decisions, and analyst ratings shouldn't represent anything more than a starting point for your research.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
The Motley Fool owns shares of and recommends Valeant Pharmaceuticals. It also owns shares of LinkedIn and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.