One of the common responses I hear when I tell people that I buy and sell stocks using my own analysis goes something like this:
“Why even bother? There are so many smart people researching these stocks with far more time to devote to it than you. They have better information and can do more homework. You might as well buy an index fund.”
Indeed, there are many people trying to beat the market and Wall Street spends a vast amount of money on research and analysis, which is likely superior to the analysis that I have the time to do.
The Data
I decided to step back and check the actual data about Wall Street recommendations. I wondered what would happen if you systematically bought baskets of each Wall Street recommendation (buy, sell, etc.), held on to them for a year and then re-balanced annually. The results from the Russell 3000 universe are below:
If Wall Street analysis were on point, there would be a more linear result. Each basket should outperform the next.
Instead, the actual data produces this choppy result. Neutral ratings outperform buys and strong buys. Meanwhile, those rare “strong sell” ratings actually outperform the sell recommendations.
This analysis of Morningstar star ratings comes to a similar conclusion. Morningstar assigns star ratings to mutual funds (5 stars are the best, 1 star is the worst). The paper linked to analyzes the resulting returns after Morningstar issues the rating. The 5 star ratings outperform the 1 star ratings, but in the lower end it gets lumpy. The 1 star rated funds outperform the 2 and 3 star funds.
Also, consider this tidbit of stock market history which is quite shocking: in November of 2001, more than half of Wall Street analysts rated Enron as a buy or better.
Why This Result?
This leaves one to speculate: why do we get this result? I think there are three key reasons:
1. Human nature makes us extrapolate the present into the future. Analysts aren’t immune to this tendency.
Any analyst can look at Amazon, for instance, and tell me that they are doing a great job at growing their revenues. Any analyst can look at the retail sector and tell me that retail is hurting as more consumers shift their buying preferences online. In 2006, any analyst could tell you that the financial sector was enjoying a nice upswing and would also provide you with a very convincing explanation (i.e., the “financial supermarkets” created in the wake of Gramm-Leach-Biley were leading to higher returns on equity for banks) or that the energy sector was doing well thanks to advancing oil prices (they would probably say that oil would continue to increase due to growing demand from emerging market economies and peak oil). In 1999, any analyst could have looked at the growth in fiber-optics and told you that JDS Uniphase was doing very well and would continue to do so because the rapidly growing information economy would fuel greater demand for fiber optic cable. Analysts are frequently deceived because they underestimate the tendency of things to change. Some have expressed this sentiment with greater eloquence.
When you look at a Wall Street research recommendation, what you’re seeing is the conventional wisdom. The conventional wisdom is usually an extrapolation of what is going on right now into the future. The conventional wisdom usually becomes more ingrained when we listen to really smart people provide convincing explanations for why the trend will continue.
Things change and the conventional wisdom is frequently incorrect. It is human nature to take trends and extrapolate them into the future. This worked for our ancestors trying to evade a predator, but it doesn’t work when trying to predict changes in the modern world. The tendency of trends to reverse (for great businesses to falter, for bad businesses to turn around) defies the ingrained expectations of human nature.
2. Wall Street doesn’t care about valuation as much as it should.
Valuation plays another role. Stocks with “strong buy” recommendations are frequently overvalued. Of the 32 analysts covering Amazon, for instance, 23 of them have a strong buy recommendation. Clearly, valuation isn’t even considered the analysis, as Amazon currently has a P/E ratio of 179.84. Amazon might continue it’s ascendancy, but history shows that stocks with such lofty valuations frequently under-perform. Amazon’s business may continue to succeed, but that doesn’t mean that the stock is a good investment when the lofty valuation is taken into consideration.
3. Wall Street prizes access to management.
Wall Street values good relationships with companies. Sell ratings or critical analysis hurts the relationship that banks have with companies. As this Bloomberg article explains, relationships are the reason that only 6% of the 11,000 Wall Street recommendations are sell ratings.
Relationships are critical to Wall Street. A good relationship with a company means that the Wall Street banks are more likely to underwrite deals for those companies, such as mergers and acquisitions, which generate high fees for the banks. Good relationships can also improve their odds in being selected to underwrite new loans for that company, another important source of income.
Another reason is that they want access to management to get better information about the companies. They feel that access to management is a critical component of gathering information about potential investments.
My unconventional view is that talking to management can be counterproductive. Management is always going to say things that are positive about the company no matter what, so what’s the point of even entertaining them? CEOs typically get their jobs not because of any technical expertise, but because they are masters at dealing with people. They are typically wildly charismatic people.
Charisma is usually not matched off with any real expertise or insight. When Wall Street analysts talk to management, they are simply being charmed by a charismatic person into believing a more optimistic portrayal of the company than is actually deserved. I think an investor is better off going to sec.gov and reading through the financial data published in quarterly and annual reports rather than allowing themselves to be manipulated by a charismatic management team.
The great Walter Schloss had this to say about meeting with management: “When I buy a stock, I never visit or talk to management because I think that a company’s financial figures are good enough to tell the story. Besides, management always says something good about the company, which may affect my judgment.”
Conclusion
My conclusion is simple: small time investors can win at this game even though we are at an informational disadvantage. This is because much of the Wall Street “analysis” is clouded by behavioral biases, an under-appreciation for value and a tendency to be manipulated by management.
A small investor can also operate in corners of the market where Wall Street banks fail to look, as their focus is usually on extremely large companies that can generate fee income.
Moreover, as has been discussed previously on this blog, Wall Street is increasingly short term oriented. In a world where investors obsess over their returns on shorter and shorter time periods, an investor with a long term outlook and willingness to under-perform in the short run is at a significant behavioral advantage.
I’ll end this with a quote on this subject from the master himself, Benjamin Graham:
“The typical investor has a great advantage over the large institutions . . . Chiefly because these institutions have a relatively small field of common stocks to choose from–say 300 to 400 huge corporations–and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list–say, 30 issues or more–that offer attractive buying opportunities.”
PLEASE NOTE: The information provided on this site is not financial advice and it is for informational and discussion purposes only. Do your own homework. Full disclosure: my current holdings. Read the full disclaimer.
