Whether the stock market is on a raging bull market or going through one of its common corrections, there are analysts hard at work. They cover individual stocks, bonds, funds and the entire market as strategists. While most analysts share the same goal - to evaluate the investment worthiness of a company - their methods and practices can vary widely. Analysts also tend to bunch up their coverage on large and popular stocks, leaving little room for a company to surprise the market with uncovered news. It also leaves many companies open for discovery. If most of the analysts are covering the big stocks, it's up to the smart investor to find the next undiscovered stock. (Thinking about relying on analyst recommendations for your next trade? We'll show you what to watch out for. For more information, read What To Know About Financial Analysts.)
The Business of Analysts
Analysts can work on the buy side of the business evaluating companies for their own use and selling their research to the market. Sell side analysts on the other hand, typically provide insight to the buying public and can often have some vested interest in the company they are touting. Either way, both types of analysts spend the majority of their time digging through financial statements and earnings reports. Unfortunately for the average investor, there seems to be no rhyme or reason as to how an analyst chooses what companies or why they choose that path. They have also been faced with deciphering a broad array of analyst opinions as many companies have moved away from the traditional "buy" and "sell" ratings of the past. (Find out more in Analyst Forecasts Spell Disaster For Some Stocks.)
Anyone who spends time reading investment research reports knows how much attention some stocks get. Like a popularity contest in high school, it is inevitable that analysts for the buy and sell side gravitate toward the most popular stocks. Unless an analyst is assigned to that sector or is considered an expert on that company, the choice can be for many reasons. There has always been some connection between market capitalization and analyst coverage, so it is inevitable that large companies like IBM and Exxon will always have in-depth coverage.
Here are some examples of the number of analysts covering some of the larger stocks in January 2010:
|Company||Sector||Market Cap (billion)||# of analysts covering|
So why are more than 20 different analysts needed to cover one company if companies are not allowed to provide any insider information to anyone? You also have to wonder how much analytical work one would need to actually do if so much has already been done. One of the problems with so many analysts is that there are certain times in economic cycles when because of uncertainty, many analysts estimates fall within narrow ranges. This can be particularly odd as many analysts tout their earning estimate models as being better than the rest. While this is a little suspicious at times, the quarterly reported numbers are often close to the average of all the analysts' estimates.
While this makes the analysts look like they are doing a pretty good job of covering these companies, how can they really add value? You can't pick up a financial newspaper or turn on the financial news without hearing about "earnings surprises". That's because earnings surprises can drive a stocks price movement up or down. If all the analyst does is report the publicly available news, you might as well just buy the company and ignore the analyst. The good analysts who dig deep into research do add significant value, but you have to read beyond the headlines. Although analysts implement superior models and further research than what is common to the every-day investor, analyst estimates are often immediately reflected in the share price of the covered firm. (To learn more about earnings surprises, read Surprising Earnings Results.)
The Ratings System
As recent as the technology bubble, most analysts were using more simplified ratings like the old formats of simply buy or hold. This was very straightforward and easy to understand, but this also left too many variations of buy and sell up to interpretation. This was even more apparent as the investment banks taking the new stock public stamped a buy rating on that stock.
While some firms still stick to the straight forward buy or sell, many have changed to a more complicated system of numbers, letters and ratings such as "strong buy". You can see "initiate coverage," "market perform," "market underperform" or even "neutral" as a rating. The numbers and letters are a little easier to read and more black and white. For the average investor, here is a good rule of thumb: if an analyst has any bit of positive language in their rating, it's their indirect way of saying buy the stocks. So if you trust that analyst, buy away. Once the language starts moving even slightly negative you can assume that is as close to a sell call as actually saying it. This range of ratings makes it easier for analysts to be kind of right or wrong and takes some of the pressure off of them from calling the tops and bottoms. In the volatile times, you need to catch the subtle clues.
While an analyst covering a company alongside a large crowd may not be the best source for breaking news, especially since those opinions will already be incorporated into the share price, you can potentially benefit from an analyst who covers those unloved stocks or future gems. Here is a list of companies in January 2010 that have few analysts covering them. The major difference in companies like these, beside their much smaller size, is the divergence between the analysts' estimates. An investor can benefit if they pick the right analyst to follow. A common phenomenon in finance occurs when there is a small amount of coverage for a particular sector or stock. These investments tend to outperform the broader activity of the stock market as earnings often will be outside the range of analyst predictions.
|Company||Sector||Market Cap (million)||# of analysts covering|
|Dave Madden||Consumer Goods||$740.70||5|
|Schweitzer Mauduit||Consumer Goods||$1,300||1|
|YadkinValley Financial Corp.||Financial||$57.42||5|
All of these companies are very different, but they do share limited analyst coverage. This could be for many reasons like lack of institutional ownership, low volume, limited activity in the investment banking area, being out of favor or just too small for anyone to care about them. There are thousands of companies like these just waiting for investors to look into, and the analysts have already started the process for you. All you need to do now is compare and contrast the estimates and decide which one you think will most likely occur based on your personal estimates and analyst track record. If you bet on the right side and the company lives up to the estimate - or perhaps beats it by a large margin - then you may have found an unloved gem.
While companies with limited analysts are a great place to start for finding those next gems, the real treasures are those companies that have yet to be covered by any analysts. Just like those with limited coverage, there are many reasons that no analysts have covered them. The disadvantage of investing in companies yet to be covered by analysts is that you are completely on your own and will have to start from scratch. You have to figure out the best type of earnings model to use, determine the stability of their dividends, etc.
This disadvantage is also the key to finding uncovered gems, especially when markets have had significant corrections. Finding stocks that have not been covered is the best place to find the next hot company, maybe even the next Apple just waiting to be discovered. Some of the best times in the economic cycle to find these gems are turning points where one company is exceeding the others due to some proprietary product or service, or is capitalizing on other companies downfalls by buying up tattered and discounted assets among the ashes of a recession. (Find out what types of stocks perform well in a downturn. Read Industries That Thrive On Recession.)
The Bottom Line
The business of research seems to reinvent itself ever time we see some major market changes, but the basic concept never changes: helping investors understand companies and evaluate the investment worthiness of the company.
Analysts tend to bunch up around companies with large market caps and even those that are not so big but are in the popular crowd. You can pick and choose who to follow from both the buy and sell side, but you are not likely to find any uncovered gems here. Chances are good that all those analysts have scoured through the financials and company guidance. In these cases, herds tend to flock toward the middle and your chances of seeing large earnings surprises are limited. The real gems of the future are found in those stocks that have little coverage or have not been covered at all. (Find out why little companies have the greatest potential for growth. Check out Small Caps Boast Big Advantages.)