Lessons from Wall Street’s Poor Forecasts

Recently, I read a fact that most would find surprising. According to Bloomberg, the 50 stocks with the lowest Wall Street analyst ratings at the beginning of 2012 (the companies Wall Street expected the worst from), outperformed the S&P 500 by seven percentage points in 2012.

That isn’t an unusual phenomenon. Looking at this year yields similar results. Companies with the most Wall Street sell ratings in January outperformed the market by a median 15 percentage points. Those with the most buy ratings underperformed by more than seven percentage points. An investor would do better to buy when Wall Street says sell.

There are two lessons here.

Incentives in the financial analyst industry aren’t set up as one might expect. Many professional stock analysts are not focused on the accuracy of their picks. “Until recently, brokerage firms did not even track the accuracy of their analysts’ opinions,” according to a 2009 The Financial Times article. Institutional Investor magazine once surveyed those that pay the lion’s share of fees for Wall Street research (mutual funds, hedge funds, and other large investors), asking what attributes rank highest in selecting an analyst. “Of 12 factors ranked in order of priority, stock selection placed dead last,” wrote the Times article. “Industry knowledge was the key quality that institutions wanted in analysts.” Such institutions perform their own stock selection; they look to analysts only to supplement their knowledge. Individual investors who follow analyst upgrades and downgrades are looking for help in the wrong place.

The second lesson is key and leads to my value investing approach: it pays to take a contrary path in investing.

In 1999, when stock markets were as overvalued as they had ever been, Merrill Lynch analysts issued 940 buy recommendations on stocks and only seven sell ratings. Morgan Stanley recommended 670 buy ratings and zero sell recommendations. This is in stark contrast to 2010, after the market crashed: less than 30% of stock recommendations issued by Wall Street brokerage firms were buys and more than 50% were hold recommendations, according to Bloomberg.

In 2005, the investment bank Dresdner Kleinwort wrote a paper on the history of financial forecasts and found something interesting. When a composite of analyst forecasts on things like bond yields and stock prices were overlaid with what actually happened, the forecasts had a consistent lag. A few months after bond yields rose, analysts forecast that they would keep rising. A few months after yields fell, analysts switched their forecasts and predicted yields would continue to fall. It is human nature to run with the herd in investing, but still surprising to see that trait in so many professional analysts. “Analysts are terribly good at telling us what has just happened, but of little use in telling us what is going to happen in the future,” the report said.

It’s the same with stocks. Most of the companies analysts downgraded last year had poor stock price performance leading up to the sell recommendation. Short-term price movement, however, is not a great indicator of long-term price movement. If anything, it’s a counter-indicator. That’s why, whatever the details of their approach, contrarianism is a trait you’ll find in the best performing investors. This contrarianism is at the heart of the Warren Buffett style of value investing, and at the heart of everything I do at Liberty Hill Investing.

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