Wall Street Can't Pick Stocks, Its Research Never Tells It All

Barron's has just published its semi-annual rankings of Street's best stock recommendations, and it is not a pretty picture.  In my book, Full of Bull, the first and most important point that I stress up front in Chapter 1 is that Wall Street analysts are bad at stock picking.  Brokerage emphasis lists are not credible.  Good investment advice is not the analyst's job.  Professional qualifications, incentive compensation, and the main audience-institutional investors-do not emphasize the function of stock picking.

The Street is a giant marketing machine.  Most institutional investors such as mutual funds hold stocks, long positions.  When such organizations own several million shares of a stock, you can imagine their reaction to a Street downgrade or a forceful negative opinion.  Corporate executives also corrupt Street analyst research.  Their control over analysts is subtle but effective, giving preferential treatment to analysts with bullish recommendations and punishing those with negative opinions.  Is there any wonder why the Street has a congenitally favorable bias?

Barron's assessment of the performance of brokerage firm emphasis lists is an embarrassing exposure of the ineffectiveness of these recommendations.  Most brokerage firms sport their top stock recommendations in rankings with titles such as a Focus List, Alpha List, or America's Conviction Buy List.  Studies have shown these "best" recommendations do not perform materially better than all other favorably-rated stocks at the firm.  Even worse, most often they lag overall stock market results.  In 2007, more than half of these emphasis lists trailed the market.  In the first half of 2008, the emphasis lists of all but one declined in absolute terms.

And now comes the first half of 2009 results in Barron's.  Over a 12-month period just four firms' lists did better than the -23.6% decline in the S&P 500 equally weighted, while nine did worse.  All 13 lists showed losses.  Three of the outperformers were small firms that most investors have hardly even heard of-McAdams Wright Ragen, New Constucts, and Edward Jones.  The more widely-known brokerages almost all lagged-Wells Fargo, Merrill Lynch, Morgan Stanley, Charles Schwab, Credit Suisse, and Goldman Sachs.  The winner,  McAdams, had the worst performance last time around, so there is no consistency either.

So what are Wall Street analysts good for?  Their job function is to pursue information about the companies and industries they cover, evaluate and gain insight on the future prospects for those companies, and form opinions on the fundamental outlook for these companies.  Analysts then divulge their best research insight on a priority basis to institutional clients, in-house traders and institutional sales staff.  The Street is beholden to giant institutional investment pools because they generate the bulk of commissions and trading.  Retail clients are a low priority.

Thus, I was not surprised to read in the Wall Street Journal an exposé of Goldman Sachs practice of having its analysts meet regularly with its traders and institutional sales force to discuss the stocks they follow.  In one case an analyst holding a Neutral opinion on a particular stock, told the internal group that it "was likely to head higher." Goldman employees called some 50 major institutional clients and the stock moved up almost 6% over the next few days, according to the Journal.  The analyst's research report indicating this bullishness was published six days later.

Another well-kept Street secret that I reveal in Full of Bull is that research reports never contain an analyst's complete viewpoint.  Analyst body language or subtle leanings on a stock are rarely put in writing, but rather expressed verbally to only key internal associates and major institutional clients.  In a follow-up WSJ story on the Goldman procedure, it was stated that at various times "short-term trading tips differed from Goldman's long-term research."  In other words, the verbal comments differed from the formal investment rating printed in the research reports.  Individual investors are only privy to brokerage reports, never privileged to obtain the juicy insight from an analyst that is offered to big institutional investors.

Wall Street brokerage firms focus first and foremost on themselves, and after that on institutional clients such as mutual funds and hedge funds.  One of the most important profit centers is the trading desk, transacting myriad trades each day as a principal (generating profits for the house account).  As an individual investor, use Street research for its information and understanding of a company's business and its industry.  Do not give any credibility to the conclusions or recommendations.  Know your place at the bottom of the brokerage firm client priority rankings.  You are on your own and must realize that you cannot depend on the Street for good, timely, or impartial investment advice.