There are several reasons I typically ignore Wall Street analyst calls. The most compelling is the fact that sell side recommendations over the long term have been shown to underperform the market with above average volatility. Those are lose-lose metrics for investors.
Such poor performance is largely attributable to analysts being backward looking when they make research calls, despite the fact that they are supposed to be analyzing the equity market, which is a forward looking mechanism. Too many times analysts will upgrade stocks after the firms report strong numbers and vice versa, which does nothing to add to investor returns relative to the benchmark index they are trying to beat. Successful investing requires insight into the future, not reaction to the past.
To illustrate this point, consider an upgrade from UBS analyst Wenlin Li on Monday. Li covers Baidu.com (BIDU), the internet search giant in China. Baidu reported second quarter earnings of $1.61 per share, above consensus estimates of $1.44.
Prior to the earnings report Li had a sell rating and $150 price target on Baidu, which was trading over $300 per share. That in itself appears to be a contrarian call, which would be commendable (wrong, but commendable nonetheless). After the strong report was released, despite only a small upside surprise, Li upgraded the stock to neutral and raised the price target to $380 per share, a stunning increase of 153 percent.
How does a single quarter’s earnings beat of 12 percent explain a 153 percent increase in one’s fair value estimate for a stock? It doesn’t, not by a long shot. This is the epitome of a completely useless Wall Street research call.
To see how this analyst messed up so badly, we only need to look at the changes made to their BIDU assumptions. Li now estimates 2009 revenue at $658 million, up from $542 million, while 2010 and 2011 sales are revised upward by 33% and 38%, respectively. Gross profit as a percentage of sales estimates were also revised upward, by 60% this year, next year and 2011, and net profit was revised up by about 40% per year.
Remember, an analyst’s sole job is to follow companies and estimate how much revenue they will bring in and what proportion of that will flow through to the bottom line. Without solid insight into these metrics ahead of time, analyst calls are of little use to investors, which unfortunately is the case more often than not on Wall Street.
Full Disclosure: No position in BIDU at the time of writing, but positions may change at any time