The Pros and Cons of Analyst Stock Ratings

Synopsis:

The financial media devotes a tremendous amount of coverage to ratings, price targets, and commentary from stock analysts. But any trader who has closely tracked analyst targets, ratings, and forecasts also knows analysts miss the mark quite often and are prone to changing their tune seemingly at a moment’s notice. Here’s a look at the pros and cons of professional equity analyst research.

Pros of Analyst Research:

Much like any other professional degree or certification, any equity analyst with a Chartered Financial Analyst (CFA) certification has at the very least a baseline level of competency in analyzing markets. CFA holders must complete three difficult exams, obtain three years of relevant work experience and meet other requirements as well.

A CFA certification doesn’t necessarily mean an analyst is a better stock picker than a person running an anonymous social media account or your next-door neighbor. But it does mean that the analyst has at some point demonstrated a thorough understanding of money management and stock analysis.

Sell-side analysts also often have access to information, resources, and data that are difficult or extremely costly for retail traders to access. No matter how good of a Googler you are, sell-side analysts at Wall Street investment banks have connections, access, and analytical tools far beyond anything the typical retail trader would ever use. They often also have inside connections within the companies they cover. They get a unique insight into the mood and the overall work environment of a business.

Cons of Analyst Research:

While CFAs have the knowledge and skillset needed to effectively analyze a stock, it doesn’t mean all analysts are good at their jobs. In January 2001, Bear Stearns analysts Robert Winters and Robert Franson famously initiated coverage of Enron with an “attractive” rating and set a $98 price target, representing about 23% upside from the price at the time. By the end of the year, Enron was bankrupt and exposed as a fraud.

Another thing to keep in mind about analyst research is that investment banks and the companies they cover often do a lot of business together. Explicitly exchanging favors or access to analysts in exchange for positive ratings and coverage is unethical and illegal. However, it doesn’t mean that analysts don’t feel pressure to speak favorably of companies when businesses should do so.

Some of that bias is likely reflected in the unbalanced distribution of analyst ratings. One study by FactSet found that 49.5% of more than 11,000 total analyst ratings were “buy” ratings, while only 5.2% were “sell” ratings. The rest were neutral.

Analysts also change their minds about a stock at a moment’s notice. Any decent trader or analyst needs to be able to change their mind if the information surrounding stock changes. But understand that an analyst “buy” rating and a $100 price target can easily change to a “sell” rating and $60 target at the drop of a hat.

The Bottom Line:

Stock analysts can provide a qualified, unique analysis of a stock that can be extremely useful to traders and investors. But their opinions, assumptions, and forecasts can also be biased and inaccurate.

Instead of blindly following an analyst’s take on a stock, research the opinion of several analysts that cover the stock and use your judgment to draw your conclusion.

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