In our office we have wide-ranging lunchtime discussions about things affecting the market. A recent topic was the impact of the analyst recommendation.
The question before us was the following:
Suppose that you had a feeling that an analyst from a big-name firm was going to downgrade a stock. Further suppose it was someone you had been following, and you saw some signs. What would be your reaction?
There was general agreement in our office discussion that we would sell in front of the announcement, assuming under the rules of the question, that we had no "inside" information. (We don't cheat.) Why? A downgrade by the analyst at a big firm has a big effect.
The Effect of Analyst Recommendations
In the old days -- that would be ten years ago, or so -- people would jump on information from a sell-side analyst. The rating change would (somehow) get to the clients paying the largest commissions and then to the sales force, and finally to the customers of the Big-Name firm. Presumably the institutions doing massive trading would hear the news early, so one can guess where the individual investor ranked.
Maria Bartiromo changed this system and changed the rules for information dissemination. Through a lot of hard work, she started to reveal these rating changes in her CNBC segments from the NYSE floor before the market opened. No one had ever done this before, and she was subjected to a lot of "hazing". Once she got the information going, the firms involved realized that this was a story that could not be bottled up. Eventually, they all joined in. Everything that people now expect to see, all of the news about upgrades and downgrades on web sites and TV -- none of this happened before Maria. Much of the openness of information, the coverage from the NYSE floor, and a lot of full disclosure has come through her pioneering efforts.
What are the Effects?
Stocks still make big moves on analyst downgrades (or upgrades). The volume is pretty strong. This suggests one of the following situations:
- Institutional investors are reacting to the sell-side research;
- Individual investors are reacting to the news; or
- Traders are trying to beat everyone to some new play.
Whatever the source, one cannot question the impact. There is an immediate effect from a downgrade (or upgrade) by a big-name firm. The news reports often do not mention the analyst's name. It is enough that "Big Firm" chose to employ the analyst.
Analyzing the Reports
We know the extent of analysis by individual investors: Zippo! One client invested her own money by going to a popular website and looking for the stocks with the biggest gap between the average target price and the current stock price.
Meanwhile, when we actually read the reports they were disturbingly similar to term papers from our University days -- including many of the same problems of analysis and logic. Some of these analysts were the sort who struggled to get a "B" in classes. When we read Andy Kessler's inside story, Wall Street Meat, (now on our recommended reading list) our suspicion was confirmed.
A lot of young people with little expertise had an enormous impact on stock prices. This has changed a lot in recent years, and for the better.
How to Interpret Information
The starting point for anyone wishing to understand analyst reports is the work of Scott Rothbort, my colleague at TheStreet.com. Scott is a Professor at Seton Hall, a money manager, and an author. This is a combination that commands respect. An individual investor should take the time to read his entire "Finance Professor" series, but we wish to highlight a particular article: Investment Research: Ignore the Ratings, Read the Reports. This article describes everything one should know about the history of research reports, where to find information, and how to interpret it.
If one needs additional confirmation of this thesis, it is readily available. Part of the excellent work from Bespoke Investment Group, described in a CNBC interview, was one of their B.I.G. Tips, summarized as follows:
Sometimes when there is nothing good to say about a stock, our findings show that the best course of action may be to just go out and buy it. Our Dow Outcast screen buys the five stocks with the lowest overall analyst rating at the start of each year and rebalances yearly. Since 2001, these names are up 48.2%, while an equal weighting in each of the Dow 30 stocks would have resulted in a gain of 30.4%. If an investor took the other extreme and bought the five most favored stocks at the start of each year, they would currently be down 0.2%.
This is a very dramatic conclusion which should get our attention. Interested investors should check with them to find their best picks for 2008.
In a way it is disappointing to see one of our own best methods get such attention. We wanted it to be a secret! Our principal program for individual investors has beaten the S&P 500 by more than 7 points a year for ten years. A key element of the approach is to find unloved stocks. We assign negative ratings to companies with too much analyst support. It works -- sometimes not right away. And some calls fail, but the odds are with us.
There is an irony here. Let us take last Friday as an example. A big firm downgraded Fannie Mae, (FNM) and Freddie Mac (FRE) to a "sell" rating. This is pretty dramatic, since "sell" ratings are still pretty rare. The impact of the downgrade affected the entire financial group and the entire stock market, showing the power of the analyst report (which we have not specifically reviewed).
The market turned on news about bond insurers, as we described.
Our opinion, based upon our public policy expertise, is that any solution to mortgage problems will work through the GSE's, so we have both Fannie and Freddie on our "buy watch" list -- no positions yet.
It is a matter of time frames. The immediate effect of downgrades is negative. The longer-term effect may well represent an opportunity. The short-term trader might act one way. The investor might see a good risk/reward situation.