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Pay
Attention to
Analysts - Just Don't Follow Their Advice
The analyst buy/sell ratings and earnings forecasts
shown on many financial sites contain important information that could
help you make better investing decisions.
No, I’m not talking about following analysts’
buy/sell advice. My research, and that of many others have found that, in
general, you’d fare just as well buying ‘sell rated’ stocks as those the
analysts are advising buying.
That said, there’s valuable information to be had
from analysts’ ratings and earnings forecasts, if you know how to
interpret it. I’ll give you the details in a minute, but first some
background.
Who Are Those Analysts?
Those ratings and forecasts come from analysts employed by full
service brokers and other firms that derive most of their income from
investment banking activities. Investment banking involves bringing new
issues of stocks to market, advising on mergers and acquisitions, and
providing other services targeted to institutional investors. The analysts
write research reports describing their outlook for stocks that they
follow, but those reports go mostly to clients and to institutional
investors. Individual investors have only limited access to the reports.
However, firms such as Zacks Research and Thomson
Financial tabulate the individual analyst ratings and forecasts for each
stock, and the resulting “consensus” data is readily available. The
information that I’ve found most useful can be derived from the number of
analysts rating a stock and the consensus earnings forecasts. I’ll start
with the number of analysts.
Number of Buy/Sells Important
Most of us dream about discovering a ‘hot’ stock ahead of the
crowd. Observing the number of analysts covering a stock will help you do
that. Here’s why.
Stock prices, like so many things, reflect supply and
demand. A stock goes up on days when more buyers want to buy shares than
sellers want to sell. Conversely, it drops when sellers outnumber buyers.
The supply side of the equation is the number of
shares available for sale, which is a relatively stable number. But demand
is another story, and that brings us back to analysts.
Analysts Create Demand
Regardless of how great a stock’s fundamentals, its price won’t
move much if nobody knows. It’s analyst coverage that creates investor
awareness. Some full-service stockbrokers employ hundreds of individual
brokers.
When an analyst issues a report, it goes to the
firm’s brokers, which, depending on the company, could number in the
hundreds. The brokers, in turn, forward the reports to their clients. In
many cases, the clients are institutions such as mutual funds, hedge
funds, or pension plans, each capable of purchasing tens of thousands of
the shares of a single company.
Thus, when an analyst initiates coverage of a stock,
it opens the door to thousands of investors who may never of heard of the
stock before. The heightened awareness translates to increased demand.
For instance, shares of True Religion Apparel could
be had for $14 during the summer of 2005 when only four analysts were
following the maker of fashionably torn jeans. But the number of analysts
steadily increased, and nine where covering True Religion when its share
price peaked at $23 last October, up more than 60 percent from its
mid-2005 price.
It’s easy to find the necessary information. Several
financial sites list the number of analysts making buy/sell
recommendations on a stock today, as well as one, two, and three months
back. For instance, to find it on Yahoo Finance (finance.yahoo.com),
get a
price quote, click on
Analyst
Opinion and scroll down to Recommendation Trends.
Look For Increasing Coverage
Once there, notice the trend in the number of analysts rating a
stock today compared to one, two, and three months back. For instance, you
may notice that three months ago, only two analysts were making buy/sell
recommendations, but now, three or four are following the stock. Once the
trend starts, it’s likely that more analysts will join the parade. I’ve
found the effect most pronounced when the number of analysts increases
from two, three or four, in the past, up to six or seven now.
What’s interesting is that what the analysts think
about the stock doesn’t matter much. That is, stocks seem to move up when
analyst coverage increases, regardless of whether the analysts are
advising buying or selling.
Watch Earnings Forecast Trends
As I mentioned earlier, analyst’s earnings forecasts also
contain valuable information. For the stocks they cover, analysts usually
forecast earnings for the current and next quarters, as well as for the
current and next fiscal years.
The tabulating services average the individual
analysts’ forecasts to come up with the consensus numbers that you see
displayed.
As you probably already know, share prices usually
move up when the consensus forecasts rise, and drop when the forecasts are
revised downward. What’s important is that the consensus forecasts often
move in trends. That is, once forecasts start to move, either up or down,
they often continue on the same path for a few weeks.
Why does that happen? It could be that once one
analyst makes a change, others reexamine their assumptions to see if
they’ve missed something. Apparently, many times, they decide that they
have and revise their forecasts in the same direction, which drives the
share price further up or down.
Trends Predict Surprise
But there’s more to the story. Trending estimates often predict a
corresponding earnings surprise when the firm reports its quarterly
results. An earnings surprise is the difference between analysts’
forecasts and reported earnings. It’s a positive surprise when earnings
come in above forecasts and a negative surprise if they fall short.
Positive estimate trends signal potential positive
surprises, and vice versa.
Negative Surprise Count Most
Significant positive surprises, say more than
two cents per share, typically drive the share price higher. Any
negative surprise, even one cent, usually drives
the share price down. Unfortunately, share prices usually drop more in
response to negative surprises than they gain for positive surprises.
Thus, it’s especially important to notice when earnings forecasts are
trending down, warning of a potential negative surprise.
Earnings trends are most significant in the weeks
leading up to a quarterly report.
As was the case for buy/sell ratings, you can find
the earnings forecasts on many sites. On Smart Money (www.smartmoney.com),
get a
price quote, select
Earnings, and look in the Forecasts Revisions section.
Not Holy Grail
As I’ve said before, nothing always works in the stock market, and
the two strategies I’ve described here are no exception. But, hopefully,
they will be useful additions to your analysis toolbox.
published 2/18/07 |
