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Buy or Sell: Should Analyst Ratings Still Matter to Investors?

By  +Follow July 1, 2014 9:56PM
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analyst ratings, stock analyst ratings, trust buy ratings stock

Netflix (NFLX) shares raced to all-time highs on Tuesday, soaring 6% to $470 after Heath P. Terry of Goldman Sachs upgraded the stock from neutral to buy, raising his price target from $380 to $590.

The upgrade may seem run of the mill, but actually tells a perturbing story related to analyst ratings.

In two distinct ways, external motives and conflicts of interest increasingly making analyst ratings and price targets unreliable for everyday investors, and in some cases, even rendering them useless. It is crucial that investors understand these inefficiencies and potential ulterior motives when factoring analyst opinions into their research and investment decision making.

Analyst Professionalism vs. Reputation

The timing of the aforementioned Netflix upgrade is curious, as Terry had been neutral on the company for years. Now that the stock has rocketed from $50 in 2012 to almost $470 on Tuesday, an over-800% gain, Terry’s prior analysis on the company has proven less than worthless. His reason for the upgrade was more or less Netflix's “subscriber growth,” a blatant trend that has been obvious since last year.

Thus, it’s debatable whether the upgrade reflected a change in heart or a desperate move to manage his reputation. Terry has been chasing Netflix, periodically raising his price target as the stock rose. Yet, he remained “neutral” on the stock. Another big gain for the stock would have been humiliating, and an analyst’s reputation means everything to his professional value.

Of course, it’s unfair to single out Terry. Reactionary reputation management seems to be the common practice in the industry. Without credibility, his or her research and educated advice is worthless to investors.

The reputation conflict is surely harmful to the average investor, who often has difficulty deciphering what is honest analyst research and what is externally motivated. This conflict is, therefore, an aspect of investment banking and stock analysis. Investors need to acknowledge these potential external motives and understand how they may factor into the analyst’s opinions.

Media Ratings and Outlandish Price Targets

Another inherent conflict of interest lies within the growing popularity of financial media. Despite their status as news sources, most business media outlets exist for one purpose: to make money.

Simply reporting the news is boring and unprofitable, so media sources often encourage analysts to make outlandish predictions and price targets to get people talking. “This guy’s insane” or “that analyst could be on to something” are quickly circulated throughout the Internet and social media. The content then receives more views and the analyst gets more attention — a mutually beneficial arrangement for the analyst and media source.

For example, Ed Zabitsky of ACI Research currently has a $38.57 target on Apple (AAPL). With shares hovering just shy of $95 and with Apple sitting on $25 per share in cash, the estimate is simply insane. Minus cash, Zabitsky’s target would value Apple at three times earnings, making it the cheapest blue chip stock in the history of the stock market by a long shot.

To understand what’s going on here, we must first understand this madman Zabitsky. He runs, by himself, a boutique firm in Toronto called ACI Research. In other words, Zabitsky is a relative nobody compared to analysts at Goldman Sachs, Morgan Stanley, and Bank of America.

So what in the world was Zabitsky doing on CNBC explaining his Apple price target for six whole minutes? How did he get his coverage on Bloomberg, the New York Times, Forbes, and other sources?

The answer is that it is mutually beneficial for Zabitsky and these news sources to create controversy together. Zabitsky garners attention for his small firm, while media generates controversy, views, clicks, and revenue.

This phenomenon is a massive, problematic inefficiency. News sources have the impossible tasks of maximizing revenue and reporting unbiased news. Revenue often trumps truth, especially given that most major news sources are owned by publically traded corporations.

What Investors Should Do

All this being said, investors need to be wary of the potential motives behind analyst ratings and the media content they consume.

Stock analysts have their career to take care of. To protect themselves, they often give safe price targets to avoid a humiliating mistake, rather than formulating a well-researched thesis and sticking to it.

Meanwhile, business media is tied up in a complex relationship between profit-maximization and reporting valuable news. News sources are expected to host well-qualified analysts, rather than nobodies to keep the public informed. This isn’t often the case, because bold predictions generate headlines and maximize revenue.

These conflicts are creating headaches for average investors, who are finding it more and more difficult to obtain beneficial information in the investment world.

 

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.


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By  +Follow July 1, 2014 9:56PM
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