A few months ago, some Harvard Business School professors came out with a study on what factors drive analyst buy recommendations. Read on, and I’ll explain the problem with analyst recommendations, what the professors found, and how you can profit from all this.
Wall Street recommendations
Wall Street analysts have a variety of conflicts of interests and are far too positive; as such, their recommendations are known to not be that useful. Being negative is hard for analysts, as there really is no incentive for them to be negative. Negative reports don’t get people excited, don’t drive much business, and often management teams will stop speaking with analysts who are negative. Also, if an analyst makes a small error in a negative report, investor relations departments are not forgiving, whereas in a positive report, IR departments are much more forgiving of small errors.
With no incentive to write negative reports on companies, only 6% of U.S. analyst recommendations are sells. Internationally, the number is slightly higher, with an average of 9% of recommendations as sells around the world.
Given their overly positive bent, what do you think would be analysts’ top factors?
Take a moment to think about it…
The results, which are organized by the location of the analysts, are interesting both for what analysts found very important and what they found least important.
Factors that drive buy recommendations for analysts
(A = Asia, E = Europe, L = Latin America, U = U.S.)
|Factors / Importance||Low||Moderate||High||Very High|
|Ability to execute strategy||AL||U||E|
|Quality of top management||L||AEU|
|Superior products or services strategy||AEL||U|
|Balance sheet strength||AELU|
|High performance compensation||AEL||U|
|Projected industry growth||E||ALU|
Analysts called out projected industry growth and quality of top management as factors they consider to be very important. While it is good to hear that analysts find management extremely important, it is worrisome that projected industry growth is the other most important factor to them.
Studies have shown that analysts are terrible at estimating growth in both the short and long term, consistently overestimating growth. A study that looked at analyst estimates from 1984 to 2006 by Patrick Cusatis and J. Randall Woolridge of Pennsylvania State University found that actual earnings came in roughly 40% below analyst expectations.
|Time Frame||Estimated Growth||Actual Growth|
Similarly, a study by McKinsey entitled “Equity Analysts: Still Too Bullish,” which looked at analyst estimates from 1985 to 2009, found a slightly higher gap between actual earnings and analyst expectations. The McKinsey study found actual earnings growth was typically 6%, with estimates ranging from 10% to 12% a year.
Favoring projected industry growth can make analysts little more than cheerleaders for growth stocks. This can cause stocks to rise much more than their growth prospects would reasonably allow. Good examples of stocks where this happened or is possibly happening include:
|Stock||# of Analysts||% With Buy/Strong Buy Rating||% With Sell Rating|
|Apple Inc. (NASDAQ:AAPL)||39||85%||0%|
|Las Vegas Sands Corp. (NYSE:LVS)||20||75%||0%|
|3D Systems Corporation (NYSE:DDD)||7||57%||0%|
Analysts kept extremely bullish ratings on Apple Inc. (NASDAQ:AAPL) as it grew revenue nearly 75% a year from 2010 till 2012. Apple’s stock got ahead of itself in 2012, hitting a high of $700 per share before coming back down to the $400 level, where it sits now. Analysts kept strong buy ratings on Apple throughout 2012. Anyone who listened and bought and held Apple Inc. (NASDAQ:AAPL) at any point in 2012 is at best even, at worst down 40%.