3 Reasons to Question Stock Analyst’s Recommendations

Why do analysts’ reports exist?

Possibly like sheep, it is of innate human nature that we seek social proof and validation. When we fall in love with a stock we researched on, we actively seek out affirmation in the media. Often, you would be finding analysts’ reports and consensus that are in your favour.

The more satisfied you get, the more you want to read up on them. Very soon, you will end up just listening to the analysts’ consensus.

The reason why the industry is so lucrative is that it is able to exploit the human psychology. The logic is very simple.

Majority of investors are always looking for activity and are unable to sit still. They will always be researching for the next stock to buy, and which stocks within their portfolio should they be selling.

In this article, we will be sharing 3 reasons of why we should be questioning such recommendations from analyst reports.

Conflict of interests

Based on this fact, it is clear that there is a huge upward bias that exists in the industry. This is unsurprisingly so if you take a closer look at their pay structure.

While good quality companies would not mind analysts featuring a sell on them. There will be companies that would question analysts who recommends a sell rating. Furthermore, they may reject future interviews based on this incident.

Furthermore, looking at the business model of brokerage firms, they profit from such buy and sell activity. Their revenue model is based on transaction volume. The greater the number of transactions, the more profits they would be earning. Hence, it is advantageous to them to keep changing the buy and sell rating for a company as well.

Lack of reliable results

The above table simply shows that most analysts don’t actually know what they are doing. You are probably as close to the prediction if you decide to flip a coin instead.

Given that there is a culture of conformity in the industry, analysts are afraid to make estimates that are far off from the consensus. There seems to be an apparent safety in numbers. If they collectively get it wrong, at least the entire industry gets it wrong together. If an individual gets it wrong, he or she will probably be sacked very soon after.

When the industry gets it right, the media exalts all the analysts. When they get it wrong, whatever they said are simply brushed aside. For instance, when Donald Trump was first inaugurated as the 44^th President of the United States, most analysts forecasted a strengthening dollar within the next year due to his bombastic promises about tax cuts and whatnot.

Of course, we now see that the dollar has weakened so much since then.

Seems like not even the best economists are able to predict the future.

They simply reiterate what the management says

Many of them claim about how the company’s growth prospects are getting better and how market share is going to increase by XXX times over the next 5 years. Many of these claims are taken wholesale from the management’s words and honestly who are we kidding, the management has an incentive to bump up the stock prices.

When the analysts get it wrong, they can simply push the blame to the management for having such an outrageous claim. If they get it right, they will take the credit. It is simply foolproof.

Conclusion

From the above three points, it is clear that there is little meaning in taking the analysts’ consensus to heart. While it may sometimes seem assuring to know that the so-called experts out there have the same stand as you, know that to beat the market, you have to think differently.

In the short run, the consensus & sentiments may drive the market but in the long run, the truth about the company will prevail. This truth is the fundamental value of the stock, not what the analysts think it is.

To be a successful value investor, you have to develop the courage to think and act differently. It is often a difficult journey but trust us, self-discipline will pay off!