April 14th, 2009

Analysts Ratings: Embrace or Ignore?

It’s earnings season but I’m going to give it a different spin. I’m not going to guess whether analysts’ estimates have been too low (or too high) and therefore stocks are undervalued (or overvalued). I’m not going to weigh whether corporations’ expectations about the future are positive or negative to mean anything.

What I am going to discuss is what Wall Street does with those reports. We know they issue politically correct (and confusing, non-actionable) opinions such as: Underperform, Peer Perform, Above Average, Hold, Outperform, Neutral, Market Perform, Sector Perform, Average and, sometimes, even a straight Buy. But they rarely issue a sell recommendation.

These and other euphemisms are how the various Research Firms rate the performances of stocks they follow (I think they mean future performance but you often can’t tell whether it might not actually have been about a company’s past performance as they issue their call). Furthermore, those who follow fundamental analysts’ make decisions based on whether those ratings have changed since the last time the firm made the call and how one analyst’s call compares with the calls of other Research firms (those changes are labeled as Initiate, Upgrade and Downgrade).

The media “talking heads” love this time of the year because they can win points with these Research Firms by mentioning them on the air and the action they took on various stocks as if it were truly newsworthy. If the stock has a wide enough following and the Research Firm is prestigious they might even flash an “Alert” on the screen, play irritating sound effects and announce the action taken as a bulletin. For about 4 weeks, it fills up time between the repetitious commercials.

But how much is all that “news” really worth in the long-term big picture. It could be if you’re an institutional investor, a money manager or a mutual fund because it serves as cover, protecting you from a claim of having made what appeared to be arbitrary and capricious decisions.

To the individual investor, however, I’m not sure it means much or makes any difference. One could run sophisticated analysis on the accuracy of changes in ratings (if I were in college, that might make for an excellent term paper) so I constructed a simple visual test. Yahoo Finance reports on these changes; I tool RIMM (Research in Motion) as an example:

The yellow is when RIMM was essentially trendlless, green the bull market and red, obviously, the bear market.

The list includes only those firms that issued multiple ratings changes during the period. I could have sorted the list by firm, by type of change or the rating itself. But I chose to sort the list by the date it was issued so I could match it up with the stock’s chart.

My primary takeaways from looking at the ratings changes are (click on chart to enlarge):

  • Ratings deal exclusively with whether the firm feels the stock’s price is over, under or in line with the investment firm’s fundamental assessment of it’s theoretically correct fair market value, on whatever basis that might be made.
  • Since the rating focuses on the stock’s price, it doesn’t appear like any consideration is given to the general economic environment and the health of the overall market.

This approach allows ratings to be lowered even as the momentum is moving the market up, carrying with it stocks like RIMM in its wake. Or allows ratings to be raised either as the market peaks or before the bottom in the market’s decline has been assured.

I’m sorry. While investment firms’ ratings may be satisfactory for institutional investors who have tons of money and years of time to wait the bad times out, they individual investors should consider them irrelevant, meaningless and ignored. As a matter of fact, the point I’ve been trying to make here is that individual investors are better served by following stock and market momentum swings and investing primarily by timing the market.

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