Monday, March 7, 2011

Analyst Ratings

Analyst ratings are not useful in helping us determine if we should buy a stock.  A buy rating by itself means nothing.  How and when an analyst changes their rating can be informative, but I never go by ratings.

Analysts are real people too.  They only have so much time in the day, just like you and I.  There is no possible way an analyst can provide ratings for hundreds and hundreds of stocks.  Jim Cramer on CNBC's Mad Money recommends we spend at least an hour a week on each stock we invest in.  The point is even an analyst can only rate a limited number of companies.

Buy-side analysts research companies for fund managers.  The purpose of a sell-side analyst is to provide a compelling case for owning particular stocks.  If there is only so much time in the day, then some of that time can be used to rule out some of the candidates, but the remainder of the time has to be spent building a case for buying others.  In a finite universe of companies, some will always be sells, some holds, and others buys.  In other words, it is less about absolute performance, and more about relative performance - how one company will perform compared to another.  If we are in the middle of a bear market and the prices of stocks are plummeting, it is cold comfort to know that my stock has crashed to a lesser degree than a competing stock.

Yet, the analyst always has to have a buy recommendation.  That is their job!  In addition, analysts work for firms that have business relations with companies that want to go public, or issue new shares, or raise money using their services.  When an investment firm provides money to a company for an initial public offering (IPO), the investment firm needs to find buyers for the stock.  Have you ever received one of those calls where some advisor you have never met before wants you to buy the hottest stock since, well, ever?

Analyst ratings affect the price.  Watch for times when an analyst has it wrong and continues to raise their target price despite not liking the stock.  At some point that same stock could get so strong relative to their other ratings, they have to change from a sell, or a hold, to a buy.  When that happens, it will normally be good for the price of the stock.  Watch for any change in earnings estimates.  That is a good time to reevaluate our own target price and how many shares of a stock we might want to own, if any.

I aggregate the earnings estimates to determine a fair price for a company's stock.  If there is a herd instinct among buyers, it can also be said for analysts.  When everyone is saying the same thing, I check for alternative scenarios.  I would never buy on somebody else's say-so, and especially not on an analyst's buy rating.

Do you use analyst ratings?

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