The stock market is a complex machine made up of intricate technologies, financial experts, and investors.
Some of the most highly-regarded experts on Wall Street are the research analysts who spend their days looking into opportunities in the stock market. These analysts make their money by sharing their opinions about what they believe will happen in the future.
Knowing that successful investing is born in research, many beginner investors make the decision to blindly follow the opinions of analysts rather than doing their own research when making investment decisions.
This is a very dangerous activity. Here’s why.
What Do Stock Market Research Analysts Do?
Research analysts — also called investment analysts, securities analysts, equity analysts, sell-side analysts, or financial analysts — are financial professionals charged with analyzing the financial stability and potential for growth of publicly traded companies.
Research analysts look into company metrics like historic revenue growth and earnings growth. They also dive into market conditions.
For example, if the company being analyzed is in the computer gaming industry, the analyst researches how large that industry is, how fast it’s growing, and what percentage of the industry the company has tapped into.
Once their research is complete, research analysts make predictions, including:
- Earnings Per Share (EPS). Stock market analysts will attempt to predict the earnings per share (EPS) that companies they follow will produce. EPS divides the total net income generated in any given period by the number of shares of the company in existence.
- Revenue. Research analysts also take a stab at predicting how much revenue the company will generate over the next year. Investors pay close attention to revenue because when revenue grows, it shows that sales are increasing, helps to increase profit margins, and ultimately leads to increased profitability for the company.
- Share Price. Finally, research analysts make an attempt to predict what the price of the stock will become over the next year. This statistic is known as the price target.
Stock market analysts also make recommendations and providing ratings, generally including:
- Buy. A buy rating, sometimes called an Outperform or Overweight rating, insinuates that buying the stock at the current share price is a good deal. This rating means the analyst believes that the stock has the potential to produce gains that outperform the overall stock market’s returns in the next 12 months.
- Hold. A hold rating, sometimes called a Market Perform or Equal Weight rating, suggests the stock is likely to perform in line with the overall stock market. Analysts don’t believe that you’re going to earn returns any larger than the average across the market but believe that growth is still likely ahead.
- Sell. The sell rating, also called the Underperform or Underweight rating, is a recommendation that investors avoid the stock if they don’t already own it and sell it if they do. This rating means that the analyst believes the stock’s performance will lag compared to the stock market as a whole, and purchasing of the stock could lead to losses.
Why You Shouldn’t Blindly Follow the Opinions of Research Analysts
With predictions surrounding earnings per share, revenue, and share price, coupled with ratings from research analysts, many newcomers believe the research legwork has been done for them, deciding to dive into any stock analysts deem to be a strong investment opportunity.
After all, isn’t that the analysts’ job? Why put the time into researching something that the professionals have already analyzed?
There are plenty of reasons to research your own investment opportunities rather than blindly following analysts. While research analysts are highly paid experts that have a knack for making decisions in the stock market, their opinions often can’t be trusted as the basis for objective investing decisions, as you’ll see below.
1. A Vested Interest
Research analysts don’t make predictions on stocks for the pure joy of helping investors. They have to make their six-figure salaries somewhere. As a result, these analysts often work for:
- Brokerages. Although regulatory authorities are supposed to keep sell-side analyst opinions as far away from brokerages as possible in order to maintain objectivity in the investing process, that doesn’t seem to be happening. Brokerages often make investment recommendations based on the research provided by their analysts. This often creates a bias, with analysts recommending stocks that are best for their employers rather than the investors their employers serve.
- Mutual Funds, ETFs, and Index Funds. Analyst opinions have the ability to move the market. A positive opinion about a company can send a stock soaring while a negative opinion can cause sharp declines. Mutual funds and many exchange-traded funds (ETFs) employ research analysts, which gives the analyst a vested interest in forming an opinion about a stock that’s in the best interest of the fund’s portfolio, and not always an unbiased depiction of what to expect from the stock.
- Hedge Funds. The Big Short Squeeze involving GameStop, AMC, and several other stocks outlined the battle between hedge funds and retail investors. However, some of the research analysts most trusted by retail investors happen to work for the hedge funds that bet against them. Again, the analysts’ employment at hedge funds creates a potential bias when making predictions about trending tickers.
The bottom line is that research analysts aren’t working for you. Who they work for can create biases that make their work unreliable at best; the average retail investor simply shouldn’t trust them.
2. Analysts Are Highly Inaccurate
You would think financial professionals who spend their lives analyzing opportunities in the stock market would be pretty good at what they do. You might be surprised to learn that the average stock market analyst isn’t nearly as accurate as you may think.
Here are the stats analysts don’t want you to know, courtesy of FactSet.com:
- Historic Performance: The majority of publicly traded companies listed on the S&P 500 beat analyst expectations when reporting financial results, and this percentage is growing quickly.
- EPS Surprise: In the fourth quarter of 2020, 81% of companies listed on the S&P 500 reported a positive EPS surprise, meaning that these companies beat analyst expectations. That’s a huge miss on a key valuation metric used by most investors.
- Revenue: In the fourth quarter of 2020, 79% of companies listed on the S&P 500 beat analyst expectations in terms of revenue.
Those are staggering statistics that show the highly paid research analysts who are expected to be pretty accurate had up to an 81% failure rate. If your investment advisor admitted to being wrong 81% of the time, would you continue to pay them to manage your investment portfolio?
3. Misleading Predictions Artificially Inflate Success Rates
Unfortunately, Wall Street doesn’t gauge the success of Wall Street analysts based on the accuracy of their EPS, revenue, or share price predictions. Research analyst success is gauged solely on their ratings system. What percentage of buy-rated stocks grew, and what percentage of sell-rated stocks fell?
Analysts use this incomplete view to their advantage, artificially inflating their success rate.
For example, say an analyst has a buy rating on a stock and expects earnings per share will come in at $0.50 on revenue of $50 million for the quarter. They know that when companies beat analyst expectations, investors react in positive ways.
So the analyst may make a public prediction that the company will report earnings of $0.45 per share on $47 million in revenue. These publicly stated estimates leave room for error and then some.
When the company reports its financial results, it is more likely to beat expectations than it would be if the analyst had shared their true opinion.
Moreover, as a result of the beat expectations, the stock is more likely to climb, making the analyst’s buy rating more likely to be placed in the books as an accurate one.
4. Stock Price Predictions Are Only Good for One Year
Building wealth in the stock market is a long-term process. Most successful investors invest with a time horizon measured in decades.
However, research analysts only follow 12-month time frames. A stock with a great outlook in the short term may be a horrible long-term investment.
Moreover, short-term predictions in the stock market are exposed to the short-term volatility that’s become the norm, making them highly unreliable. After all, stock market analysts can’t predict major events that may cause short-term volatility.
One of the best examples of this is the COVID-19 pandemic.
An analyst may have seen great promise in a well-run and profitable travel company in May of 2019, with no sign that a pandemic was coming that would grind most travel to a halt. The analyst may have expected strong revenues and earnings over the next year, coupled with incredible share price growth.
By the end of the 12-month time frame, the analyst would have been way off. In May of 2020, travel stocks were having a horrible time. Almost nobody could expect a travel stock to have a great year when half the country is locked down.
Many of these stocks saw a strong recovery as 2020 came to a close and travel restrictions eased, but the research analyst’s view doesn’t go any farther than the 12-month mark.
So was the analyst right or wrong for liking the travel stock in May 2019? This example demonstrates why the short-term nature of analysts’ predictions makes them pretty unreliable.
5. Research Analysts Are More Likely to Rate a Stock a Buy Than a Sell
The vested interest research analysts often have in the stocks they cover clearly comes out when you look into the statistics of the ratings they provide.
According to FactSet, there were 11,147 analyst ratings on S&P 500 companies as of December 31, 2017. Here’s how the total universe of analyst ratings broke down:
- Buy Ratings: 49.5%
- Hold Ratings: 45.3%
- Sell Ratings: 5.2%
Sure, it’s true that more publicly traded companies do well than fail. However, you’d be right to question whether 94.8% of stocks are worth buying or holding.
Moreover, it’s impossible for 49.5% of stocks to outperform the market, 45.3% of stocks to trade in line with market performance, and just 5.2% of stocks to underperform the market. The numbers just don’t add up.
Wall Street Analysts Have Their Place
Although it’s never a good idea to blindly follow anyone into an investment, including research analysts, these analysts do have their place. For all their shortcomings, here’s how research analysts can provide valuable insights to everyday retail investors:
1. As a Source of Validation for Your Own Research
Hopefully, by now, you know that you should do your own due diligence before you invest in a company. However, it’s nice to have some way to validate your research.
Analyst opinions are a great way to do that.
Sure, analyst predictions aren’t always accurate, but if you’ve done your own research and believe that a stock is going to rise in value, it’s a good idea to look into what percentage of analysts rate the stock a buy.
If the overwhelming opinion among analysts is a buy rating, chances are you’re on the right track with your research.
TipRanks is a free way to go about seeing how many analysts cover a stock and what their overall opinion on the stock is.
2. As a Clear Red Flag on Stocks In Trouble
Analysts generally have a bias when it comes to stocks they cover, and they tend to rate stocks in a positive way. As such, if the vast majority of analysts that cover a particular stock rate it a sell, that acts as a big red flag that something is wrong with the company.
Sure, you don’t want to blindly follow analysts into a fire, but you also shouldn’t ignore blatant warnings that a stock is likely to fall. If lots of analysts are heading for the exits, they might be smelling smoke.
3. As a Gauge of Popularity Among Investors
Analysts don’t tend to waste their time researching stocks that nobody’s interested in. Instead, they want their research to be read and their name to be seen.
As a result, you can use the number of analysts that cover a stock to gauge that stock’s popularity. After all, the more popular a stock is, the more liquid an investment in it becomes.
For example, consider the following:
- Amazon.com (AMZN). Amazon.com has 31 analysts covering the stock, all of which rate it a Buy. This suggests that an investment in Amazon.com would be a highly liquid one — there are lots of buyers for it on the market — because the stock has garnered quite a bit of positive coverage.
- Tesla (TSLA). 29 analysts are weighing in on Tesla stock, with seven Buy ratings, seven Sell ratings, and 15 hold ratings. Once again, the high level of analyst coverage suggests that an investment in Tesla would be highly liquid.
- Gevo (GEVO). Gevo, on the other hand, has two analysts covering it, both of whom rate it a Buy. Although the ratings and opinions are positive, the lack of widespread analyst coverage suggests that the stock is less popular than Amazon.com or Tesla, and thus, less liquid. That means you may have a harder time finding a buyer to pay your asking price if you decide you want to sell your shares.
The simple fact is that it takes investors to move the stock market. If nobody’s buying or selling, prices aren’t going up or down.
As such, the popularity of a stock you’re considering investing in should play into your decision to invest.
This article admittedly has been critical of stock market analysts. The fact is, professional analysts are human beings who make their best efforts to succeed in their careers, just like you. They’re not bad people, but their interests aren’t always aligned with yours.
Interests among two conflicting parties rarely align; that’s why nothing gets done in Congress. Nonetheless, each party plays an important role, with analysts and retail investors essentially representing separate parties in the case in the stock market.
The bottom line is that nobody is going to hold your best interest as highly as you will. As such, you shouldn’t trust anyone’s opinion more than your own when it comes to your money. Instead, do your own research and look to experts to validate your own educated opinions.