I want to tell you why you should never invest based on a ‘buy/sell’ rating from an analyst, but to do it I have to open up about my worst (hopefully ever) investment.
Every bank on Wall Street pays a large research staff to pump out stock ratings every day. You can access buy/sell ratings with a click, for free, whenever you want. Tune in at any time to ‘infotainment’ stations like CNBC, you’ll likely see a screen full of analysts yelling buy or sell into your living room.
These are intelligent, talented, and highly educated people. They digest reams of data and publish dozens of pages, all with a suggested action and specific price target. I’m here to tell you it’s just a coin flip.
When I first entered this business, I met for lunch with the UBS manager and a good friend who was an advisor there at the time. I remember a particular exchange very clearly; my biggest concern was that I had no real knowledge of finance or capital markets. I had an engineering degree and brief banking exposure in consulting, but my professional experience to date had been inspecting bridge girders and developing use cases for bank products.
‘Don’t worry about that,’ the boss said, ‘if you’re willing to put on a suit and grind every day, we’ll handle the finance part.’ I heard a brief pitch about the amazing research capabilities of the Firm, how I would have the smartest minds on Wall Street advising me on what to buy/sell (the pitch that every rookie receives). A few weeks later, I accepted a position in the UBS training program.
Fast forward 8 years: the friend was my business partner, and we had a thriving practice at Morgan Stanley. I had taken my first manager to heart. ‘Don’t over think things’ he would say, ‘when in doubt just smile and dial’ (the phone).
When it came to investing we ultimately relied on the research of the Firm. Morgan Stanley required any advisor managing discretionary money (when the advisor buys and sells on a client’s behalf without their input) to keep a file proving they did due diligence on the investment. They considered anything their analysts marked as ‘Buy’ to be perfectly fine. If there was a ‘Sell’ rating, you had to argue for and justify why you held it in an account.
That sounds logical,…but what happens when the analysts are woefully wrong?
In the summer of 2014, I owned a stock called Seadrill. Not only did I own it, so did hundreds of my clients. Seadrill was an oil drilling company, and my partner and I had heard the Firm’s energy analyst talk passionately in person about his belief in the company. We believed him, and we bought a ton of the stock.
Oil was flirting with $120/barrel then, but within months it would began a cascade that would leave it down 80% from its high. In early 2014 Seadrill was trading above $40. By late 2015, it was $2. An absolutely mind-blowing 95% loss in 1.5 years!
I personally lost over ten thousand dollars, but many clients fared much worse. Some fired us, and rightfully so. It was an agonizing couple of months, and with each drop, the analyst would keep his recommendation in place.
Here’s a snapshot of the analyst report from August 2014. Overweight (another way to say buy), price target $48:
Here’s an update two months later. Still overweight, but price target now $31:
Seadrill would eventually trade at $1, and then go bankrupt. If you think the Morgan Stanley analyst was the only one, here’s a Wall St Journal headline from that winter discussing how analysts across the Street were all recommending energy stocks….alllllll the way down:
Analysts have a natural bias to recommend you buy stocks. The firms want and need you to invest so they make money. Plus, if the majority of analysts say buy, people will push prices up. That keeps you invested, the analyst looks good, the bank keeps making commissions,…everyone’s happy!
Firms are supposed to keep their analyst population separate from the investment banking side, which does deals by having relationships with a company’s ownership, but how likely is that? If you’re the analyst with a glaring ‘Sell’ rating on a stock, and the investment banking guys were trying to court that CEO, good luck making pals on the firm’s softball team.
Don’t get me started on price targets. They’ll simply adjust those by a few dollars every time the stock moves and call it ‘analysis.’ A broken clock is right twice a day too.
As Philip Van Doorn notes here in a May 2018 article, guess how many S&P 500 stocks had a majority ‘Sell’ rating? Zero.
Nerd Wallet did a study in 2012 looking at the performance of these analyst stock-pickers. Among their conclusions:
- Only 51% of analysts ratings were correct (coin flip).
- 62% of analyst ratings were buys, 4% were sells. (emphasis mine)
Analysts have the same natural cognitive and behavioral biases that you and I do. Worse, their firm would really like it if they found reasons to keep the stock a ‘Buy.’ How can that advice ever be objective?
Seadrill was a turning point in my career. I was angry. I was embarrassed. I was a fool. It was one of the most stressful times of my life, and I really wanted to blame someone. Anyone.
I soon realized what is now obvious: I was the problem. I had simply followed the Firm’s research instead of doing my own. I started to read, I started to research, I questioned everything. I learned how to invest based on evidence instead of headlines, as I wrote about here. I learned about trend-following, and how that would have prevented something like Seadrill from happening. I found mentors to my current practice and investment approach. I found a wonderful community we all call ‘FinTwit,’ a group of brilliant, like-minded financial professionals on Twitter that openly share their research and ideas and admit their uncertainty.
Don’t learn the hard way. If you’re going to invest on your own, read every book you can. Research relentlessly. Find a mentor. Hire someone that believes in evidence-based investing. Whatever you do, please don’t flip on CNBC and follow the analysts.