Are Stock Analysts Worthless?

by JT McGee

Picking stocks isn’t as easy as it’s made out to be.

Unlike the private markets, there’s a daily mark of just how good you are. If you buy a McDonald’s franchise, you can’t go online and look up its value every 10 minutes like you could with McDonald’s stock.

Mr. Market is a finicky guy. Sometimes he offers you to buy companies for less than the cash they have on hand – Pawn Star stocks. Sometimes, Mr. Market laughs at you, like when Warren Buffett missed out on the dot com boom, or when he bought a railroad at the depth of the recession. (See my article on Why Warren Buffett Lied to you about Railroads – I think it’s my favorite of all time.)

The point is, making a case for a particular value for a company is hard, in part because the market can disagree with you for a very long time. For equity analysts, people who get paid to value businesses, the disconnect between your valuation and the market’s valuation can make you look like a fool!

Stock Analysts tell All

An article in the Wall Street Journal shows just how backwards the business of analyzing companies really is. Researchers asked sell-side stock analysts about their daily business to publish the compiled results.

Here’s what they found:

  • Private phone calls win – Private phone calls with management were listed as the most useful source of generating useful earnings information. Private phone calls. Not public conference calls. Note the difference.
  • Bullishness prevails – Nearly 40% of analysts said that issuing lower earnings forecasts would result in losing access to management or getting ignored on conference calls.

Is this true? Of course!

Ask John DiFucci, who works for a prominent Wall Street bank (JP Morgan) but is rarely allowed to participate in conference calls for Salesforce (CRM). His criticism of the company’s business model and slowing growth earned him silence. Only the people who are most bullish on the stock get the chance to speak. Mmmm groupthink!

Less analysis, more insider information

I find it interesting how the data from the research shows analysts are most interested in talking to management. For one, management doesn’t have to tell the truth. Second, many of the most successful investors in history never really talked to management. Neither Ben Graham nor Walter Schloss did. Schloss compounded his investors’ wealth at a 15% annual pace for decades, too, mind you.

Relying on management for information gives a false sense of security. On one hand, managers know what the next quarter will look like. On another, they’re only going to tell you what makes them look good. So analysts open themselves up to highly accurate short-term information (necessary for accurately calling a quarterly earnings number) that lacks any context on in long-term difficulty.

Furthermore, investors should be troubled by the accuracy of sell-side price targets. If maintaining a high price target is the only way to keep managers happy – and keep information flowing – why wouldn’t sell-side targets always be higher than they might otherwise be?

This is why I try to stay away from analysts’ price targets and earnings guidance, besides the obvious fact that I don’t care nearly as much about one quarter as I do the next 10 years. Analysts on the sell-side have to keep far too many people happy to worry about analyzing the value of any given business.

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