Apparently, analyst stock reports are still a big deal. In fact, there are a number of sites that seem to exist solely to regurgitate analyst ratings and price targets from a Bloomberg terminal. These sites presumably churn out the latest insights from stock analysts because there is some demand for this information, which leads me to believe that it is influencing investment decisions.
Like investment advice in general, there are probably some real gems among the pool of analyst reports. But, on the whole, they are at best completely worthless. More likely, they’re yet another source of noise that does more harm than good.
In theory, a stock analyst is a trained professional who dedicates every waking hour to a single stock — visiting stores, testing products, interviewing customers and management, and coming up with a complex pricing model. In reality, they’re often stretched thin and are just as clueless as the rest of us.
Earnings Report Game
Analyst reports presumably deliver value by being predictive. But they are much better characterized as reactive. The flurry of activity that takes place after big earnings announcements is always entertaining. In late July, Whole Foods (WFM) reported disappointing earnings and guidance, and the stock price tumbled by nearly 12 percent. Analysts who had failed to predict this responded to it instead, slashing billions off their estimates of WFM’s market cap:
This, of course, makes very little sense. Analysts with a supposedly deep understanding of a company’s business model and potential — if they have some sense of confidence in their work — should be doubling down in such a scenario. On Wednesday, the analyst from Telsey thought Whole Foods was worth $20 billion. The next day it was worth $13 billion, and no longer recommended as an investment. The other five analysts who moved their price targets, on average lowered the estimate of the company’s value by $2.9 billion.
A similar but opposite phenomenon plays out whenever a company delivers a positive earnings report. Amazon (AMZN) reported strong revenues and earnings in late July, and the stock jumped 10 percent after hours. The next morning, analysts were lining up to raise their price targets. The 13 firms that raised price targets on average indicated that the company was now worth $73 billion more than they had previously thought. Two analysts implied Amazon’s value had grown by over $100 billion:
Again, this makes very little sense. Following the after hours pop, Amazon was valued at a price almost 10 percent higher than what these analysts had previously determined to be a fair value. It may seem logical to consider the potential fully realized, and close out. But the almost unanimous response is to reload on bullishness.
Delta (DAL) provides an opportunity to follow up on such upward adjustments. In December 2014 airline stocks were red hot, and Delta was coming off a 16 percent gain the previous month. So it was time for analysts who had been bullish to make some tweaks; five firms reiterated a Buy rating but bumped up their price targets:
Data Source: Finviz
The dotted line shows where DAL stock was trading almost eight months later.
There is, of course, something to be said for an objective mindset that allows for the consideration of new information and revision of opinions. But that isn’t what’s happening here; this is an admission of uselessness disguised as expertise. They threw a dart and missed, so now the board is being moved and another toss is being made. Great news: we’ve updated our model and scrutinized the recent earning figures! Oh, and please disregard everything we told you to believe last week.
Netflix and Streampix
Even when analyst calls look brilliant, there’s often more to the story that indicates the outcome is as much a result of luck as skill. In April 2012, Barclays analyst Anthony DiClemente downgraded Netflix (NFLX) to a “Hold” rating. This decision was made based upon factors including:
- Risks posed by the recent introduction of Comcast’s Streampix video service;
- Breakdowns in negotiations with Starz, which resulted in Netflix losing access to the network’s shows (which include hits such as “Ash vs. Evil Dead” and “Party Down”); and
- Limited cash on hand (about $800 million).
You can probably guess what happened from there; within a few months, Netflix began a furious rally:
DiClemente still maintained a Hold rating throughout 2014, before upgrading Netflix to “Buy” in early 2015. That call turned out to be brilliant, but it came after a string of bad ones. An investment of $10,000 in Netflix made at the time of the downgrade would have been worth about $76,000 by the time the upgrade to Buy was made. But the stock has doubled since the Buy recommendation, so that call looks like a winner.
The concerns cited in the research note are comical in hindsight; Comcast shuttered Streampix due to lack of interest in 2014, and the lack of Starz series certainly hasn’t held Netflix back. This wasn’t obvious to everyone at the time — Comcast wouldn’t have invested in the project if they knew it was a bust — but it seems like the type of insight an expert on the industry should have.
Hold! Sell! Hold! Buy!
Another example of fortuitous lunacy comes from way back in 2011, when fast casual restaurant chain Chipotle (CMG) was trading below $300. Early in the year, Morgan Keegan downgraded Chipotle to Underperform — though oddly it increased its price target from $225 to $240. Analysts cited several reasons for the downgrade:
While management has done a masterful job growing its culture, same-store sales growth, store base and operating results, creeping margin pressures from escalating food and labor costs are projected to restrict EPS growth and possibly CMG’s premium valuation.
Less than a month later, the same analysts upgraded Chipotle back to neutral (though the target price of $240, below the price at the time, stuck). And in August, CMG got upgraded again, jumping to Outperform status. One of the reasons for the upgrade was a belief that “operating trends will remain more resilient.”
So, within six months, Morgan Keegan had downgraded Chipotle to an Underperform rating (while increasing its price target), upgraded it back to neutral (while keeping the price target the same), and then upgraded it again to an Outperform rating.
In hindsight, this maneuvering looks absolutely brilliant:
It is, of course, also completely insane to make such major changes to an investment thesis so frequently. More practically, a simple buy-and-hold strategy wouldn’t look quite as impressive on a chart but of course would have performed better.
There are countless instances of similar lunacy; a few of my favorites include:
- Bank of America Merrill Lynch raising its price target on Tesla (TSLA) from $65 to $180 while maintaining its Underperform rating; and
- Needham cutting its price target on Pandora (P) from $41 to $20 — but maintaining a Buy rating.
In-Depth Studies
While the evidence above is largely anecdotal, several studies have taken a more scientific look at the skills of analysts.
A 2006 study by Mark Bradshaw of Harvard and Lawrence Brown of Georgia State examined the predictions from more than 4,500 analysts, and concluded that there is some ability to predict earnings but no ability to consistently predict stock prices. The abstract provides a delightful summary of the findings:
On average, 24-45 percent of analysts’ target prices are met, and analysts do not exhibit persistent differential abilities to forecast target prices. We show that the market acts as if it understands analyst inability to consistently forecast target prices and discounts more optimistic target prices.
In other words, the study found that there was about a one-in-four chance that a stock would close above its price target a year later. In a more respectable 45 percent of the cases, the stock topped the target at some point during the year.
A more recent study by professors at Boston College and the University of Waterloo examined more than 11,000 analysts around the globe. They found that optimism is consistent but skill is not:
- Almost 82 percent of price targets were above the price of the stock when issued (on average, target prices were 21 percent above the current price);
- 26 percent of “sell” recommendations included a price target higher than the current price; and
- Approximately 64 percent of the time, stocks stayed below the target price over the next 12 months.
On the section of its website displaying some aggregate analyst information, Nasdaq offers up the following:
Wall Street employs a veritable army of stock analysts who spend all of their time analyzing companies, issuing earnings guidance and providing “Buy” and “Sell” recommendations on those companies. Learn more about how you can use Analyst Research in your own trading.
The truthful answer would be pretty short: you can’t, so stop trading.
This article, Why Stock Analysts Are Worthless, first appeared on Dividend Reference.