What I am talking about is the buy, hold, or sell evaluations. You may hear them referred to as over-perform, in line, or out-perform.
A lot of these reports are skewed in terms of their recommendations of the buy, hold, or sell recommendations. But before we get into why these reports are skewed and why you shouldn’t pay attention to them, you need to understand a little bit about how the process works and what an analyst does.
What an analyst does
An analyst gets paid to evaluate the earnings or the projected move of a stock or a company. So let’s say that I am an analyst and I am evaluating Facebook stock. I project that Facebook will make two dollars or share or on its earnings (EPS) when it comes out on the quarter. And a lot of other analysts are projecting four or five on the EPS, than I am not really in line with what everybody else is doing. Now if I am correct, I’ll get to keep my job and probably get a nice raise because Facebook may not do as well as it has done in the past.
On the other hand, if everyone else was right, and I was wrong than I am going to get fired. This is where the problem lies. It is kind of like the herd mentality. If every other analyst out there is projecting a four dollar move in Facebook or a four dollar on its earnings per share, I am only projecting two and everyone else is right, then I am going to get burned.
On the other hand if I am correct and everyone else is wrong, than I will get a raise. But the fact is that analysts want to keep their job and they want to make sure they are getting paid. Because at the end of the year all the money managers evaluate these analysts and who they like the best. The point is that analysts will start these targets off, someone will say two dollars a share and the next guy will say 2.10 a share if he believes it’s higher. The next guy will say 2.30, the next guy may say 2.40. So they slowly start changing and adjusting these over time.
What you need to pay attention to
When it comes to these reports, what you really need to pay attention to is how often they change these reports. They do not like to do this too often but they will do it if they are starting to see a rise in the stock and they see huge momentum. But the problem is that they are still trying to stay in line with all of the other analysts because they want to keep their job.
What you really need to focus on when viewing these analyst reports is seeing what their guidance is on their earnings per share. And then see how often they change it for a specific stock or a security because the more often they change it, shows the strength of a certain stock or a certain analyst report.
So rather than just looking at a buy, hold or sell recommendation you are looking at how often these analysts are adjusting their reports. You have to keep in mind that they want to keep their job and that they will get bonuses if all the money managers are going to them and saying they are the analyst the money managers want to go with.
A lot of the money managers can not recommend a stock if it has a sell rating. So rather than these analysts adjusting their rating from a buy to a hold, or sell, they will start lowering their guidance in estimates and you can see this when stocks start weakening. So instead of them going from a buy to a hold or a hold to a sell, they will just start lowering their estimates from three dollars a share to 2.75 to 2.50 to 2.25 and so on. Until they get to the point where they are almost forced to change the recommendation from a hold to a sell or from a buy to a hold.
Keep this in mind so that you can remember why a lot of reports are skewed and why you really shouldn’t pay attention to these analyst reports in just the fact of buy, hold or sell recommendations. Instead what you really need to be focusing on is how often the analyst is changing their reports or earnings estimates.
Remember that people’s jobs are on the line and they don’t want to be different from the crowd even if they think they may be right.