Should Investors Listen To Analyst Recommendations?

By Tim Parker | December 12, 2012 AAA
Should Investors Listen To Analyst Recommendations?

If you are a fan of the financial media, you know about analysts. A constant stream of them appears throughout the day on financial TV. On one channel an analyst will tell you to buy Intel while another will say to sell it. Their advice is confusing, to say the least. One would think that if they are all looking at the same information, they would agree, but they do not. As a retail investor, this conflicting advice can be a cause for concern, so much so that you may want to stop listening to analysts altogether. But is that the right move?

Guide To Oil And Gas Plays: We've got your comprehensive guide to oil and gas shales in North America.

What Is an Analyst?
There are many things to know about financial analysts, but in general, an analyst's job is to make judgments on the quality of an investment product (most notably, stocks). There are three basic types of analyst:

  • Sell side analysts are the most public. They often work for broker dealers and disclose their recommendations to the company's clients, which often results in public disclosure.

  • Buy side analysts work for hedge funds, mutual funds and other institutional money managers, advising the firm's employees on what to buy, sell or hold.

  • Independent analysts do not work for banks or institutional clients. They sell their reports to investors.

Can They Be Biased?
When you go to a Ford (NYSE:F) dealership and ask the sales associate which make of car is the best, she will almost certainly say, "Ford." She has an understandable bias. Before listening to a financial analyst, you should understand that they could be biased as well. Some of the biases are complex, some are not. Most importantly, if an analyst works for a bank hired to handle a specific initial public offering (IPO), that analyst will be under pressure to speak positively about the IPO.

The same is true if the company is an ongoing client of the bank. In addition, an analyst that speaks positively about a large or visible company may attract their business. Some analysts are paid, in part, using a revenue sharing model. They may get a larger bonus if more money comes into the firm. A favorable rating may spark an increased amount of buying and selling, which generates more commissions.

Finally, the analyst, or the company they work for, may own stock in the companies they cover, and positive reports could generate capital appreciation. The Securities and Exchange Commission has taken steps to minimize conflicts of interest, but no amount of laws and regulations can eliminate analyst bias.

Are They Corrupt, Then?
Not at all. Bias is not the same as corruption. As with every profession, there are those analysts worthy of your trust and those who are not. It is difficult to know the difference, but as you consider their reports, focus on the parts that seem to eliminate or at least minimize bias. These include:

  • The Numbers - Analysts should arrive at their recommendation by examining large amounts of data. Earnings reports, balance sheets, performance as compared to their peers, the economic environment they're operating in and the numbers associated with that, and the stock's price, P/E ratio and other fundamental data. Allow the analyst to do your digging for you. Then, make your own recommendation.

  • The Chart - Some analysts are technical analysts. They study the charts more than the fundamental data and arrive at short and long-term trends based primarily on that. They might identify key chart patterns that you did not see. This could be valuable information for traders.

Should I Rely on the Advice of Analysts?
That is the question, isn't it? CNBC media personality Jim Cramer recently said, "Wall Street analysts don't exactly have a sterling track record." He is correct in many cases, but when it comes to records of accomplishment, many professional investors and traders have little to brag about either.

Predicting the future direction of any investment product is difficult. Noted bank analyst, Dick Bove, predicted in 2011 that bank stocks would have a large rebound. When that did not happen, he said, "I failed to understand that the fears in the market concerning banking were so great that the fundamental improvements in the economy, the industry and companies like Bank of America and Citigroup would simply be ignored."

Bove's call would later turn out to be correct, but he was too early. Whether that makes him right or wrong depends on one's point of view. For those with a long-term view, his call was brilliant. For traders who wanted short-term profits, he was wrong.

The Bottom Line
Analysts may have conflicts of interest or they may simply call it wrong. Bank analyst Meredith Whitney became famous for a series of calls including one noting that Citigroup (NYSE:C) was paying out more in dividends than they were taking in. She advised investors that the dividend would have to be cut. It was, and Whitney became one of an elite group of analysts whose calls can move markets. Since that famous call, however, Whitney, like many others, has made calls that did not pan out.

Treat an analyst's report as part of a bigger picture. Do not make it the sole basis for your investment decision. Analysts cannot predict future events with absolute certainty any better than you can.

At the time of writing, Tim Parker did not own any shares in any company mentioned in this article.

Related Articles
  1. The Death Of The Glamour Stock
    Stock Analysis

    The Death Of The Glamour Stock

  2. 7 Steps To Evaluate A Financial Adviser
    Investing Basics

    7 Steps To Evaluate A Financial Adviser

  3. What Type Of Person Needs A Financial ...
    Personal Finance

    What Type Of Person Needs A Financial ...

  4. Can Good News Be A Signal To Sell?
    Fundamental Analysis

    Can Good News Be A Signal To Sell?

  5. How Your Finances Compare To The Average ...
    Savings

    How Your Finances Compare To The Average ...

Trading Center