Pity the Poor Analyst

Wall Street analysts have long been the target of investor skepticism.

It seems like it is almost a rite of passage for business school professors to publish papers deriding the Street, pointing out that analysts are usually too bullish on the companies they follow.  A typical academic analysis will point out that many Street analysts will have "buys" on 70% or more of the stocks they follow, which usually proves to be overly optimistic.

Far be it from me to defend Wall Street, but I think that some of the criticism is somewhat misguided.

To begin with, anyone that makes an investment decision based solely on (free) Street research deserves what they get.  In any other business - autos, appliances, etc. - the consumer assumes that any research they get from their salesperson is biased.  Why should the Street be any different?

Wall Street analysts are trapped in a system where they are forced to serve several  masters.  Even if they are pessimistic on the prospects for the companies they follow, downgrading a stock's rating can often career limiting.  Wall Street, after all, is in the business of selling stocks and bonds; why would you tell your customers not to buy your products?

Company managements can become very unhappy if analysts write uncomplimentary reports.  I have had numerous analysts tell me stories of how they have been denied access to senior managements of companies they follow in the aftermath of a ratings downgrade.  No access to senior management presents a formidable challenge to an analyst following a particular group.

I was reminded of the plight of the typical Street analyst when I attended a lunch meeting yesterday.

This respected analyst follows the food and beverage companies. The stocks in his group have done very well in the past year. Investors have flocked to stocks like Coke; Pepsi; General Mills; and Kraft in search of high dividend yields and relatively predictable business models.

Problem is, the stocks today in general appear to be "fully priced" (to use Street lingo), with the P/E multiples on most stocks at roughly +30% premiums to historic averages.  In particular, when you consider that most of the growth from the food and beverage group has come from the emerging markets, it seems likely that the economic slowdowns in places like Brazil and China will hit the companies.

But here's the rub:  of the 26 stocks this analyst follows, fully 14 are rated "buy"; 7 rated "neutral"; and only 5 "sell".

So I asked the analyst:  What gives?

Well, he said with a rueful smile, in my company 's rating system, only 25% of my coverage universe can be rated "neutral".  In addition, our global strategist is recommending overweighting the stocks in my group.  And, finally, names like Coke are so widely held among client portfolios that if I ever put a "sell" on these stocks, management and the brokers would go crazy.

Hence the apparent bullish stance on the group.

Cavaet emptor.