“Can you explain why is XYZ Company such a good company to invest in,” I asked someone.
“All the buy ratings. The fact that XYZ Company has 11 buy ratings and no sell ratings makes it a investment,” someone responds.
“Fair enough. Can you explain why you barely see any sell ratings at all on Wall Street?”
That’s usually where the conversation starts and stops (at least for me), for some reasons. First, I’ve discovered that I’m debating a company’s value with someone who hasn’t though about what is being said. Second, the person is making an appeal to authority/consensus; making the case that the company is a good buy because everyone in the investment community thinks its a good buy. The person probably just doesn’t understand: Wall Street is overly optimistic.
Now there’s nothing wrong with optimism, as long as its rooted in analytical, objective reasoning. I’ve been fighting claims about a stock market bubble sense the 5th year of this bull market. It doesn’t make me a perma-bull; it just means that I see very little evidence of a bubble in the equity markets.
It’s also difficult to question things, especially when times are good; especially without the company/industry knowledge. Sometimes, it’s better just better to take the devil’s advocate position and read between the lines.
Here’s an example of the company Caterpillar. The following chart shows the Goldman Sachs analyst Jerry Revich completely missing the bottom, only to miss the rally 9 months later where the stock more than doubled in value. Given that the stock is now at $126.93 as of October 8th, 2017, at least he didn’t completely miss it.
Although this is far from the worst example. Some analyst won’t slap companies with sell ratings, even when it’s obvious that they should. Enron is a classic example; the 15 analysts covering Enron all gave the now-defunct Oil & Gas giant buy ratings right before the company collapsed.
If we looked at a more recent example of worst performing stocks (regarding growth prospects, cash flow generation, and value relative to its peers), Mattel is probably one of the worst performing stocks in the S&P 500. Yet, out of all of the ratings issued on this company within the last year, 40% were buy ratings, and only one sell rating was issued. One!
What about within the past 5 years when the stock dropped from $50 a share to $15.55 a share? Analyst issued only 3 sell ratings on Mattel within the same time frame.
This is very perplexing. Why do you only see buy ratings on Wall Street and very little sell ratings? Is it a conflict of interest between the firms being rated and the banks providing the ratings? Are stock analyst just notoriously terrible at their jobs? The answer is not as nearly complicated as you might think:
Investment Banks want your business…
Or rather, they want the business of people who can actually afford to pay them. Banks provide their equity research reports for free to the firms on the buy side who already do business with them. And they want to keep doing business with them; it’s pretty difficult to make a spread on the transaction of a stock sale if you keep putting sell ratings on everything.
Where does Robo-Analyst come into play?
Last month, Ken Sena, head of Global Internet Analyst at Wells Fargo Securities introduced their new “artificially intelligent equity research analyst” or AIERA. It’s purpose was to follow a specific number of stocks and formulate and overall view on whether the stock will go up or down in the future, whether the stocks were overvalued or undervalued.
Hilarity ensued as soon as AIERA was asked to follow big name tech stocks like Google and Facebook.
And while analysts are known to skew toward buy ratings, the new bot doesn’t seem to share the bias.
“AIERA’s approach this week appears decidedly more conservative (than last week), as she places a ‘hold’ recommendation on 11 names and even going so far as to place Google and Facebook in the ‘sell’ category,” Sena says in a new note sent out to clients on Friday.
This is at odds with Wall Street’s outlook. Facebook, a stock that has climbed 48 percent this year, has 42 buys out of 47 ratings, according to data compiled by Bloomberg. Google parent Alphabet, up 24 percent in 2017, is similarly beloved, with 34 buys out of 41 ratings.
There’s an entire debate centered around whether or not Robots are the future of Finance, replacing roles traditionally performed by humans, such as Sales and Trading, Financial Analytics, and now, Equity Research. While in some firms, robots are involved in some of the most routine task, such as filling market orders and producing detailed weekly/monthly financial reports.
At one of my previous summer internships, I remember someone asked a senior official how soon will it be until robots are tasked with conducting more advanced rolls. The senior responded, “One day, I want to be able to look at a financial report or a piece of research and have 100% confidence in the information embedded in the report. Until that happens, I don’t see this transition happening anytime soon.”
Maybe the day when Robo-Analyst replaces humans is far will occur in the distant future, but that doesn’t mean we can’t use them as a check against market euphoria and irrational behavior. Often we see market analyst place sell ratings on stocks long after the bear market has already happened. AIERA predicted that a stock would plunge, based on the information that is already made public and readily available, free from bias and incentives such as a commission check. So what does AIERA see that the 77 analysts covering Google and Facebook (all buy ratings, by the way) doesn’t see?
Considering machines are only as smart as the people who program them, maybe it’s just an error on AIERA’s part. Only time will tell.
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