Over the past three years, Wall Street firms have paid stock analysts more than $3 billion. During that time, investors have lost roughly $7 trillion.
In other words, for every dollar Wall Street has spent on analysts since early 2000, investors have lost more than $2,300.
What's the solution? Fire the analysts?
A better approach might be to choose which of the analysts' actions are worth watching.
"There is a way of using Wall Street research effectively," says Mitch Zacks, vice president and director of research at Zacks Investment Research in Chicago. "That way is to focus on revisions to analysts' earnings estimates, instead of focusing on the buy, sell, or hold recommendations."
Mr. Zacks's firm has tracked the work of Wall Street analysts for more than 20 years. One interesting finding: Over time, the stocks most spurned by analysts tend to outperform the stocks most loved by the same group.
Zacks, who recently completed a book, "Ahead of the Market," spoke to the Monitor about how the average investor could profit from his firm's findings.
What is your basic philosophy?
"We are researchers/practitioners, so everything we do is focused on whether our research and findings can be used to invest profitably.
"We think we have uncovered anomalies in the market, such as the influence of [analysts'] earnings-estimate revisions on stock-price movement. And academic researchers are beginning to agree; they are now starting to include earnings estimate revisions as a factor to explain stock price movement."
You seem to pay attention to the quantitative revisions by groups of analysts, rather than the qualitative aspects of single-analyst stock-research reports. Why?
"We were the first firm in the country to track the percentage of sell recommendations given by brokerage firms. The percentage of sell recommendations has never been very high.
"Let's look at why that's the case. A buy recommendation gets the brokers at the firm calling clients and potential clients and selling them stock. The buy recommendation can be applied to thousands of institutional and individual investors who are looking for a stock that's going to be going up in price.
"A sell recommendation, on the other hand, upsets the management of the company, upsets portfolio managers who own the stock, and can cost the investment firm lucrative investment banking business.
"Brokers can talk to any potential client about a buy recommendation; they can only talk to existing holders of a stock about a sell recommendation. Those existing stockholders hold the stock because they believe it's going higher, and they become upset with the firm for lowering its recommendation on the stock.
"Structurally, Wall Street analysts have nothing to gain from issuing sell recommendations."
You've shown clear reasons many investment firms have a bias toward buy recommendations and against sell recommendations. What do you suggest the average investor do in the face of such bias?
"Our advice is to ignore the recommendations in their entirety and instead focus on the earnings estimates.
"Earnings estimates are tied to reality because the company is required to report earnings quarterly. The analyst does not have the leeway to put a positive spin on the earnings estimate. Also, analysts can signal that things are going poorly by revising downward the earnings estimate.
"At the same time that analysts revise downward their earnings estimate, they often won't change their buy or hold recommendation. And they may even raise their recommendation. In such cases, it always pays to follow the earnings estimates.
"Looking at changes in earnings estimates is a means of unbiasing the research that is produced by Wall Street. We think revisions in consensus earnings estimates are the most powerful force affecting stock prices."
Most investors see themselves as long-term investors. How can they best apply the strategy that you're describing?
"A long-term investor [should] ... learn how to get unbiased advice for the stocks in his or her portfolio.
"The best example would be a stock like WorldCom, which I use as an example in the book. I show how the analysts continued to issue a buy recommendation while the stock fell. At the same time, the analysts were continuing to give buy recommendations, they were lowering their earnings estimates. That's why [my firm was] able to issue a sell recommendation at $45.88.
"The first sell recommendation from the analyst community, by contrast, was not issued until the stock hit $5.01, and that one sell recommendation was offset by five buy recommendations and 16 hold recommendations. The stock, of course, went to zero."
Individual investors are consistently advised to think long term about the market. What are your thoughts?
"The idea of only thinking long term about the market has gotten a lot of people into trouble.
"What happens is they buy a stock, and with this concept of long-term investing, a broker convinces an individual to hold positions where the fundamentals are clearly deteriorating, where analysts are lowering earnings estimates, where things are not improving.
"Investors are convinced to hold losing positions, to hold stocks for the long term. The problem is that companies are very dynamic entities, and they change very quickly.
"To not reevaluate your positions at least quarterly is a mistake.
"The days when you could buy a stock and keep it in your portfolio for five years, and then look at it and expect it to outperform are long since gone.
"Those stocks that have the brand name and the strategic competitive advantage - and that have the long-term characteristics that people are looking for - are generally bid up to such a level that it is no longer the case that you can just buy them and leave them in your portfolio.
"As the doctrine of buy and hold becomes more accepted, it becomes less effective."