Summary

• Many analysts stubbornly stick to their erroneous views on a company, a tendency that might contribute to market bubbles and busts.
• Conflicts of interest are likely to still exist as investors are not an analysts’ only customer given that such analysts work at investment banks that charge fees for advising companies.
• Persistent, widespread over-optimism or over-pessimism by Wall Street analysts can lead to mispricing of assets.
• Analysts exhibiting uniform positive or negative calls on any stock are excellent contrary indicators.

Anyone who has casually read any of our articles on this web site will know that we have a strong distaste for the most main stream of Wall Street analysts. Of course, our distaste is not personal as we do not know any of the analysts making calls on stocks we own or are thinking of buying or selling. Rather, our distaste is for their buy, sell or hold recommendations that appear to be made with such certainty when in truth analysts are notoriously wrong most of the time. In addition, rarely do you see analysts publicly admitting they were wrong on past stock calls or the financial news media looking backward and holding analysts who made painfully wrong calls on stocks accountable. A quick search on the Internet brings up numerous articles about how wrong Wall Street analysts are. Yet, trading day after trading day, analysts issue their buy, sell or hold calls on various stocks and stocks frequently move sharply upward or downward based on such calls. Rarely are such stock price moves based on an analyst call justified. Where such stock price move upward or downward is justified, there is typically an obvious reason for such price movement such as unexpectedly positive or negative earnings announcement. With such an obvious reason for a stock price movement do we even need analysts to tell us that such news is good or bad?

Recently, there was a powerful example of the herd mentality of analysts and how wrong they can be. As we hold a substantial amount of Corning (NYSE:GLW ), shares, we read news about this company with some interest. For the last year or so, GLW shares surged upwards but eventually slumped as the introduction of Apple, Inc.’s (NASDAQ:AAPL ) iPhone 6 product launch approached. The slump in GLW shares occurred because analysts were concerned that APPL would replace the cover glass on the new iPhone 6 from GLW’s Gorilla Glass to sapphire glass made by a company called GTAT Advanced Technologies (GTAT). AAPL backed GTAT with loans and other support and this gave the company extraordinary credibility as the current investor thinking is AAPL can do no wrong so anyone they associate will be a winner. Up until the launch of the iPhone 6, analysts were foaming at the mouth with their Gorilla Glass versus Sapphire Glass analysis and the limitless possibilities for GTAT. Let us look at one typical analyst call for GTAT in August 2014:

Piper Jaffray analyst Mike Ritzenthaler resumed coverage on … GTAT with an Overweight rating and a price target of $23.00. Ritzenthaler sees substantial EBITDA growth over the next 2 years driven by Sapphire and is recommending owning the shares into the iPhone 6 launch.

‘GTAT shares will likely react sharply to newsflow about the sapphire content of the new iPhone. ‘ he said. The device is widely expected to be unveiled on September 9th. The analyst expects this reaction despite recent WSJ reports that only the 64GB model will have sapphire cover glass. We believe that Mesa process yields (though perhaps currently suboptimal) are sufficient to cover the initial production of the iPhone 6, and poised to improve over the next 6-9 months with ramping volumes, he said. …

The firm’s $23 price target is based on an EV/EBITDA multiple of 10x their FY16E estimate of $469 million, discounted to 2015 at a 20% rate.

Wow, this analyst sounds so credible with all those quotes, financial analysis and references in regard to GTAT technology. He must know what he is talking about right? Well, apparently not as GTAT filed for bankruptcy on October 6, 2014. The day of that analyst’s overweight call, GTAT shares traded for $17.93 and today they trade for .44 (as of the writing of this article). Great call right? Do not make a buy or sell decision based solely on an analyst call under any circumstance, especially for unprofitable or barely profitable story or momentum stocks. Ever.

We did some research on why analysts are frequently wrong with their calls on stocks. We found a more scholarly article that explains that once an analyst take a position on a stock they stick with it regardless of how facts around the stock change. The author’s noted that securities analysts come up with earnings estimates that are supposed to signal the worth of a company’s stock. The authors then note But what happens when a company’s actual performance proves an analyst’s quarterly forecast is wrong? Instead of fully incorporating new information into their forecasts, many of those analysts stubbornly stick to their erroneous views on the company, a tendency that might contribute to market bubbles and busts. In particular they state:

Analysts who make extreme quarterly forecasts — above or below the consensus or median estimate among all analysts following a given stock — tend to dig in their heels after being proved wrong …. Once a company reports quarterly earnings showing the analyst was too optimistic or too pessimistic, the extreme incorrect analyst will revise his or her full-year forecast, but will move less aggressively in the direction of the earnings surprise than other analysts. This stubbornness hurts an analyst’s overall forecasting accuracy, say the researchers.

The author’s note that analysts become overcommitted to a previous course of action and [p]sychological factors like this play an important role in how people form expectations about the future. The article’s authors suggest that Persistent, widespread over-optimism or over-pessimism by market participants could lead to mispricing of assets. They indicate that stubbornness is one mechanism that might allow market bubbles and crashes. We suggest readers of this article click on the link for this article we cited for more information about such study on analyst behavior.

While the above psychological study likely has some truth about it in regard to the fact that analysts are human beings who exhibit herd like behavior, our belief is that analysts are so wrong given that many of the most well known Wall Street analysts actually work for major Wall Street companies where conflicts of interest are rampant. Conflicts of interest are a corrupting influence on analyst behavior and were famously pointed out by New York Attorney General Eliot Spitzer in the year 2000. The attorney general pointed out that investors are not an analysts’ only customers as many analysts work for investment banks-like Goldman Sachs, Morgan Stanley and Credit Suisse-that charge fees for advising companies on mergers and orchestrating initial public offerings. An investment bank would likely have more trouble winning such business if their research analysts were publishing Sell ratings on their clients. This problem was supposed to be solved after the 2000 market crash, but we highly doubt it.

Conclusion — Are analysts of any use to individual investors?

We have been very critical of Wall Street analysts and we believe deservedly so. That is not to say there are not analysts at companies such as Morningstar, Value Line or other more independent subscription based analysts who are likely more credible given that the companies that employ them need their research to be more credible to continue to have and grow their subscriber base. Unfortunately, the vast majority of individual investors are more likely to follow and give too much credibility to Wall Street analysts, to their detriment.

For us analysts are most useful when they exhibit extreme herd behavior. If the vast majority of Wall Street analysts (and the financial news media for that matter) love a stock such as APPL, we are skeptical. If the vast majority of Wall Street analysts hate a stock such as Coach, Inc. (NYSE:COH ), we become curious and do further research to see whether the stock is a potential investment for us. Analysts exhibiting uniform positive or negative calls on most stocks are excellent contrary indicators.

Disclosure: The author is long GLW, COH. (More. ) The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.