November 21, 2011/ Charles Rotblut
’Ban the analysts!’ This is what European Union commissioner Michel Barnier recently suggested. Barnier proposed banning credit agencies from rating the sovereign debt of countries undergoing bailouts. The commissioner was pressured into withdrawing his proposal for a ban, though he is still pushing for other reforms.
Barnier’s suggestion was nothing new. Analysts, covering both credit and equity securities, have long been under pressure to be positive. At a time when confidence in certain European countries to repay their debts is faltering, it is understandable that the credit agencies would be a target of backlash. Barnier had hoped that by banning rating agencies he could restore faith in problematic European countries.
The problem is not so much with Barnier’s suggestion as with the systemic pressure that analysts are under. Banking analyst Mike Mayo openly discussed how his negative comments on financial companies have caused problems throughout his career in his book Exile on Wall Street (John Wiley & Sons, 2011). Government officials and regulators are often quick to attack analysts who lower their credit ratings; corporate executives tend to be more subtle, but they still can and do retaliate. An analyst can see his access to executives limited and encounter other forms of pressure. The fact that the number of ‘buy’ ratings far exceeds the number of ‘sell’ ratings is no accident.
Analysts are not completely innocent, either. They are subject to the same behavioral errors that the rest of us are. Analysts get close to the government entities and companies under their coverage, making analysts more sympathetic to the securities they are covering. (Not to mention making it easier to miss the forest for all the trees.) Analysts also succumb to herd behavior, meaning they are unlikely to create a forecast or reach a conclusion that is significantly different from that of their peers.
This is not to say that analyst research is universally bad. Quite the contrary, I think it has value when used properly.
What should you specifically look for? First, determine the direction of the change in rating and tone of the commentary. Are the majority of analysts more optimistic or pessimistic than they have been previously? (It is easier to find the rating than the actual commentary.)
Second, for stocks, pay attention to the change in earning estimates. Though stock analysts are usually wrong when forecasting actual profits, they tend to be fairly good about predicting whether earnings will be better or worse than previously thought. (Plus, earnings estimates are easy to find.)
Finally, if you can access a research report, read it to see if the analyst points out something you missed in your analysis. You don’t have to agree with the analyst’s conclusion, but you should understand why your opinion differs. (Many brokerage Web sites make research reports available to their clients.)
This Week’s Gratis Tip
As stated above, I think earnings estimates are an effective tool for analyzing and monitoring a stock. Though analysts are questioned significantly about a change in their ratings, revisions to earnings estimates receive less scrutiny–making them a better indicator.
Great Expectations: Earnings Estimates and Their Impact on Stock Prices explains what earnings estimates are and tells you how to best use them to your advantage.
Charles Rotblut, CFA is a Vice President with the American Association of Individual Investors and editor of the AAII Journal.