Why A Wall Street Analyst's 'Buy' Rating Doesn't Always Mean Buy

Nearly every single day, countless Wall Street firms crank out analyst reports in which they issue Buy ratings on stock after stock. According to a new opinion piece penned by former Credit Suisse Group AG (ADR) (NYSE: CS) analyst Dan Davies, retail investors should be extra leery of buying stocks based strictly on analyst recommendations.

Factors At Play

In an ideal world, stock analysts would be objective observers and provide unbiased opinions and purely rational projections of where a stock is headed. Unfortunately, in reality, Davies confesses that there are a lot of outside pressures on analysts to give that all-important Buy recommendation.

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‘Buy’-ing Their Way Up The Ladder

In his piece, Davies explained how Buy ratings are typically better for an analyst’s career than Sell ratings. In general, Buy ratings keep bosses and companies happy.

Sometimes, a Buy rating may mean the difference between the CEO of a large company being the keynote speaker at a firm’s conference or choosing not to show up at all.

In addition, if an analyst's firm relies on information from the companies it covers, the best way to continue to get the best, most helpful information is to keep those companies happy by maintaining positive ratings on their stocks.

Pleasing Clients

Many times, these firms’ largest clients are institutions such as hedge funds. In that sense, Davies commented that there’s an implied “the customer is always right” pressure to issue favorable ratings on the biggest clients’ largest holdings. Keeping clients happy keeps money flowing in.

Other Pressures

In addition to pleasing companies and clients, Davies mentioned quotas and neglect as two other reasons why ratings can’t be trusted. He explained that some firms like to maintain a handful of buys within each market sector at all times, and when the boss says to find Buys, analysts will find Buys.

Finally, many analysts have a heavy workload and might not have every stock under their coverage as a top priority. In that sense, a retail investor with a large position in a stock might be better informed with up-to-date information than an analyst with that particular stock as one of 200 stocks that he or she covers.

Perception Is Reality

How strong are these factors in influencing analyst ratings? A study by the University of Texas found that nearly 40 percent of Wall Street analysts believed that they would be cut off from discussions with company management if they issued below-consensus forecasts. Of these analysts, two-thirds said that conversations with management are their most important information source. In addition, 81.5 percent of analysts named hedge funds, not retail investors, as their most important clients.

Takeaway

It’s easy to read an article about an upgrade by a reputable firm such as Credit Suisse and take the opinions expressed by a stock analyst as fact. According to Dan Davies, there is likely more at play than simply the analyst’s unbiased opinion of where the stock is headed.

This revelation is not an accusation that analysts are deliberately misleading retail investors; it is simply an acknowledgement that there are very real outside pressures on analysts that often influence their ratings.

As with any other source of stock market information, analyst reports should only serve as one small part of a trader’s ultimate decision to buy or sell a stock.

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