A compelling case can certainly be made that Wall Street has earned its tarnished reputation following the trading scandals and revelations of conflicts of interest. So why am I defending Wall Street in this edition of Willingdon Views? Well, here’s why.
The April 26th edition of The Wall Street Journal had an interesting article on the front page of section C titled, “Analyze This: Research is Fuzzier Than Ever.” In a nutshell, the point of the article is that the ratings systems used by Wall Street analysts are confusing at best and meaningless at worst. I have no argument with this, but would like to make an important distinction between ratings and research. Generally speaking, a stock rating reflects how the analyst thinks a stock will perform relative to its industry group and or the overall market. In my experience, ratings should be largely ignored. I have, in fact, disregarded them throughout my career. Therefore, I do concede that analyst ratings are confusing, especially since the rating methodologies differ across the various Wall Street firms. Worse over, the ratings often do not accurately reflect the latest opinions of the analysts, nor the short-term fluctuations in stock prices.
Which leads us to Wall Street research… While I find little value in Wall Street ratings I find great value in Wall Street research. Wall Street analysts include some of the hardest working, dedicated, and intelligent professionals I know in the investment business. The vast majority of analysts cover only a select group of stocks within an industry, and over time they know more about their companies than just about any one. The most experienced analysts develop relationships with managers at various levels of a corporation, which enhances their understanding of business strategies and competitive dynamics. Analysts also learn to read between the lines of press releases and earnings announcements to decipher subtle changes in conviction that might be a precursor to more meaningful business success.
Use Wall Street research by being specific… Investors who want Wall Street analysts to summarize all they know about a company into a simple rating – “buy,” “sell,” or “hold,” or even one of the newer ratings like “peer perform,” are using analysts the wrong way. Before consulting Wall Street, investors should develop a list of key questions. A business school professor of mine at the University of Michigan refers to this process as identifying the “Critical Factors of Success.”
I like to think about this as identifying the sustainable competitive advantages that a company enjoys over its competition. Within this qualitative process the vast knowledge of Wall Street analysts is an important resource. For example, when analyzing the pharmaceutical and biotech industries it is essential to understand the product line strength of the leading competitors. In my experience, Wall Street analysts can provide valuable insight regarding the sales momentum of current drugs as well as the future potential of a company’s research pipeline.
Evaluating trends in market share is another area where analysts can add value. In many industries, market share trends are often an accurate indication of business momentum and competitive success. Unfortunately, market share information from the leading competitors is often inconsistent and at times misleading as each company puts their spin on the data. Wall Street analysts are adept at sorting through the statistics and determining the most relevant and fair way to evaluate trends in market share.
There are many other critical variables and areas of analysis that can be strengthened by input from Wall Street analysts. So, forget the ratings but don’t ignore the research.
