Wednesday, October 21, 2009

Trusting Analysts

The herd mentality is well-documented outside the investment world. While it is not given much thought within the investment world (exceptions include discussions on the topic from both Ben Graham and Stephen Jarislowsky), it plays a large role in the investment decision-making process: investors feel much more comfortable buying stocks when they believe that others are also piling in. To that end, investors often rely on analysts, who are expected to be "experts" in guiding investors on stock selection.

But just how good are analysts at predicting the directions of stocks? A decent paper (though dated) is available here which discusses the difficulties in truly evaluating analysts. However, at the very least, if analysts were at all useful, they should be able to tell the difference between a company that has value and one that is about to go bankrupt. Yet these two very different realities in a company's status continue to baffle these "experts".

Consider how wrong analysts have been with respect to the future of certain companies just days before they have gone bankrupt. As a famous example, consider the case of Lehman Brothers. Just before it went bankrupt, there was not a single "sell" rating from any of the 19 analysts covering the company, as discussed here.

In fairness to analysts (and conversely in unfairness to investors), analysts are often confronted with conflicts of interest that may be preventing them from extolling their true opinions of a stock. So analysts might actually be better at stock prediction than we think. However, this makes them no more useful for investors, who should put little stock in what analysts say, and should instead do their own homework, in the same way as they would for any investment outside of the stock market!

When investors buy property as an investment, they consider items like the property's ability to earn rent, and the risk factors with respect to that rent. Investors don't just heed the advice of 3rd party brokers and agents. The investor mindset with respect to stocks should be no different.

While most of the information we hear about particular stocks does come from analysts, there are other avenues investors can utilize. For example, Jonathan Goldberg's site now includes a forum where like-minded value investors can discuss various topics, including stocks. By discussing the aspects of companies which value investors find relevant (balance sheet strength, margins of safety, long-term earnings etc.), investors can avoid following the mainstream herd.

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