Through a glass rosily

Globe Investor Magazine, May 22, 2008

Within constraints, analysts appear to choose their words very consistently. In a study entitled "Do security analysts speak in two tongues?" published last October, Malmendier and Shanthikumar found that analysts' buy and sell recommendations tend to be more optimistic than their detailed earnings forecasts. Why? The analysts know that retail investors pay close attention to the recommendations, but bigger players concentrate on earnings.

Even so, analysts employed by underwriting brokerage firms tend to be more positive than independent analysts. Yet they often revise earnings forecasts down just before companies issue results-making it easier for the companies to meet, or even better, the Street's consensus earnings targets.

Again, Blodget isn't surprised. Picking stocks is just a small part of an analyst's job. That job also includes client visits, detailed financial analysis, primary customer research, historical research, meetings with management and investment conferences. "For most professional investors, stock ratings are the least valuable service that analysts provide, because opinions are a dime a dozen," he says.

Putting it in even more startling terms, Blodget isn't optimistic that retail investors have a hope when it comes to playing against Wall Street. "A Little League team is always going to get destroyed by the Yankees," he once told Bloomberg. "It doesn't matter what field they play on, and that is exactly what happens when individuals try to compete with hedge funds."

As long as the retail investor believes the analysts, then there's no reason to believe he isn't right.

Ever read the back of your analyst's report? While there's lots of dull fine print to help you fall asleep, one reason to read it is to see how your analyst arrives at making a recommendation. Not all "buy" and "sell" recommendations are created equal.

Canaccord Adams, for instance, rates stocks as "buy," "speculative buy," "hold" or "sell." The buy stocks are supposed to generate a return of more than 10% over the next 12 months, while the speculative buy stocks have a significantly higher risk. The hold stocks are meant to generate a return of 0% to 10%, while the sell stocks are expected to lose money.

Okay, that seems fairly straightforward, but what if two stocks that are both rated buy are forecast to generate returns of 11% and 50%, respectively? If what you want are bullish stocks, you'll have to pay more attention to the analyst's target prices.

The stock-picking system over at RBC Capital Markets is different than at Canaccord. RBC designates stocks as "top pick," "outperform," "sector perform" or "underperform" based on sector comparisons. Top picks represent an analyst's best bets, and can only comprise about 10% of his recommendations. Outperforms are expected to materially outperform the sector average over 12 months, while sector performs will be in line with the sector and, you guessed it, underperforms will underperform the sector.

If the sector is expected to underperform the market, then that outperform-rated stock in a lousy sector may suddenly look a lot less enticing.-Scott Adams

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