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Wall Street Analysts Are Bad at Stock Picking

It’s a shocking truth, but the way the system is oriented, stock picking is not the analyst’s job. Until recently, brokerage firms did not even track the accuracy of their analyst opinions. The skill was neglected for a long time. It was just not an important part of the analyst job description. Wall Street analysts are supposed to pursue information about the companies and industries they cover, evaluate and gain insight on the future prospect of those companies, assess their investment value, and form opinions on the outlook for their stocks. We are required to assign investment ratings such as “Buy” or “Sell” to indicate a net overall evaluation. And that’s where the real issues start to surface. Professional qualifications, incentive compensation, and the main audience—institutional investors—do not stress this function of stock picking at all. An Institutional Investor magazine survey in the fall of 2006 asked the buyside institutions—mutual funds, banks, pension funds, and hedge funds that buy and sell stocks through the brokerage firms—to indicate the most important attributes they sought in sellside (brokerage) Street analysts. Of 12 factors ranked in order of priority, stock selection placed 11th. Obviously, this skill is not an analyst job function required by their foremost audience. As a result, stock picking is neglected.

For years, the Wall Street Journal published a quarterly dartboard contest. The expert stock selections by analysts and portfolio managers did no better than those picked randomly. In another test, a website featuring a newsletter called the “Paradox Investor” assessed the performance of all Sell- and Hold-rated stocks on the Street for a two-year period ending in the fall of 2003. This portfolio of negatively viewed stocks gained 53.5%, more than 75 percentage points better than the market. When stocks have several Sell recommendations, there is nowhere else for that stock to go but up. Once the fourth or fifth Sell opinion is issued on a stock, it is probably ready to recover. Analysts are usually late and are also copycats. Mutual fund money managers are no great shakes either. Barron’s conducts a poll every six months. In spring 2006, the professionals’ Sell recommendations from the year before had surged ahead by 28% compared to their Buys that climbed just 13%. And in spring 2007, these pros’ picks from the prior year actually dropped 2% but their pans were up 6%. Daunting.

If that’s not enough proof, Charles Schwab rates stocks A to F. From May 2002 through Oct. 2003, its F-rated names, those deemed to have the poorest prospects, performed the best of any category, ahead 30%. In another survey, the Wall Street Journal reported that Investars.com ranked Street research firms by how each one’s stock picks performed compared to the S&P 500 over a one-year span ending in May of 2005. You’ve probably never heard of four of the top five: Weiss Ratings, Columbine Capital, Ford Equity Research, and Channel Trend. The major brokerage Buy-rated stock results were strewn further down the list. Pretty much the same pattern held true when evaluated over a four-year term. The Street pushes analysts to emphasize institutional handholding and marketing, not research and stock recommendations. No wonder the record stinks.

Insightful research analysis has little bearing on the accuracy of Buy or Sell recommendations. Brokerage analysts are usually good at providing thorough, informative company and industry research. But their investment rating track record is mediocre, and in many cases inverse to their compensation. The system spawns this fatal flaw because analysts are being compensated mainly for profile, status, clout, and industry/company knowledge rather than for investment opinion accuracy. The extreme influence and impact of analysts can result in great damage when investors are misled. Jack Grubman is the poster boy example here. As a telecommunications analyst with more experience compared to most of the green Internet analysts, he should have known better. Apparently not, as is evident in his BusinessWeek quote about his overt, subjective cheerleading of the stocks of investment banking clients he dealt with: “What used to be conflict is now a synergy.” He shunned his fiduciary duty to be relatively unbiased as an analyst. Grubman’s incestuous investment banking behavior destroyed his research credibility. Several of his top recommendations were advocated almost all the way into Chapter 11—Global Crossing, MCI Worldcom, and others. He’s now permanently barred from the business.

Analyst compensation, often more than one million dollars annually, is unrelated to the performance of their stock recommendations. A portfolio manager’s investment record can be tracked daily in the mutual fund listings. But analysts are not paid for the accuracy of their stock opinions. Their income depends on institutional client polls, overall eminence and influence, institutional sales and trading evaluations, aid in doing investment banking deals (there is still involvement here), and overall subjective judgment by research management.

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