Analyst Call on Baidu Shows Why Most Wall Street Research Calls Are Useless

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

Merrill Lynch’s David Rosenberg Gets Less Negative

For those of you who don’t know Merrill Lynch chief economist David Rosenberg, he has been very bearish on the U.S. economy for a long time, long before the recession hit. Some give him credit for predicting how things would play out, while others criticize the fact that he was years early and therefore missed a lot of the upside before being right about the drop. Both points are reasonable, but I bring his name up because he was on CNBC this afternoon sounding much less bearish than any other time I can remember. Not bullish (heaven forbid), but not all that negative either.

Rosenberg pointed out that the stock market typically bottoms out about 60% to 65% of the way through a recession, which by his projections means we are about 90% of the way through this bear market. His downside target for the S&P 500 is 600, but he oddly adjusted that downward after his original level of 666 was reached “too early.” He gets to 600 by taking $50 of earnings and applying a 12 multiple. As you can guess for my recent writings, a 12 P/E on trough earnings is much more reasonable in my view than some of the single digit predictions of other strategists.

I typically don’t put too much weight in the absolute predictions of either the most bullish or most bearish people on Wall Street because both groups tend to stay in their respective camps far too long (Meredith Whitney comes to mind). That said, when long term bears begin to get more positive, it says a lot for where the market and economy are. If you can get people who hated stocks and panned the future prospects for the U.S. economy, to become even mildly bullish, I think that says something about how much negativity is priced into equities.

Action in Palm Stock Highlights Why Analyst Recommendations Continually Fail Investors

In recent months it would have been difficult to find a stock that Wall Street analysts were more pessimistic about than struggling smart-phone maker Palm (PALM). According to Thomson/First Call, 23 analysts follow the stock, 10 have sell ratings, and only 2 have buy ratings (the rest were neutral). In a world where brokerage firms make money by getting people to buy stocks, such negative sentiment is rare.

As a contrarian, I had actually been accumulating shares of Palm throughout 2008 in some client accounts, as hints of a possible recovery in the company’s business began to appear. Most notably, the combination of a sizable equity investment from private equity firm Elevation Partners (run by Roger McNamee, a man I have great respect for) and the hiring a former research and development star from Apple (Jon Rubenstein).

In recent months Palm had explained to investors that they were revamping their software platform and with the help of Rubenstein and McNamee were set to launch a new set of innovative products in 2009. Given how short-sighted Wall Street is, Palm shares struggled as the iPhone and new Blackberry products came to market. Wall Street analysts were negative on Palm because they claimed Apple and Research in Motion were way ahead of them in terms of products and market share. The stock actually reached a low of $1.14 per share in December, down from $4.00 just a month earlier.

The reason I was interested in the stock was not because I disagreed with the analysts’ assumptions (I too expect Apple and RIM to have higher market share than Palm), but rather because they were ignoring the fact that the global cell phone market is over 1.2 billion units. Palm could lag Apple and RIM and still collect 5% or 10% of the worldwide market, which would translate into tens of millions of units and perhaps several billion dollars of revenue. The idea that Palm had to beat out Apple and RIM to stay in business (some analysts are projecting Palm will file bankruptcy) seemed off the mark to me.

Sell side analysts generally recommend stocks based on what is known, not what could happen in the future. Even though the public knew a successful R&D guy from Apple was now heading up Palm and was slated to introduce a brand new operating system and product lineup in 2009, since the facts at the time were that Apple and RIM were crushing Palm, practically nobody on the Street liked the stock. At a buck or two though, Wall Street was pricing Palm shares based on the worst case scenario, so the risk-reward trade-off highly favored going long the stock, not betting against it.

Last month Elevation Partners increased their equity investment in Palm from $325 million to $425 million, obviously approving of the company’s plan. Yesterday at the Consumer Electronics Show (CES) in Las Vegas Palm unveiled its new operating system and a model of the Palm Pre, the first of its next generation smart-phone products schedule to be released by Sprint in the U.S. sometime during the first half of this year. Palm stock soared 35% on Thursday and is up another 30% today to about $6, bringing its total gain since the December low of $1.14 to more than 400%.

Today analysts are more optimistic (I even saw at least one upgrade) based on the promise of the new operating system and Palm Pre product. Once again, the sell side has waited until the news is out and already priced into the stock (it’s already gone from $1 to $6 in the last month) to become more optimistic on Palm’s prospects. Therein lies the inherent flaw in most brokerage firm research; they base their recommendations on announcements that the market adjusts for immediately, thereby ensuring what they have to say has little or no added value by the time clients read it.

Now, you may insist that an analyst should not blindly assume that a new product being worked on will turn out to be good, so recommending Palm before knowing what the Pre phone looks like would not have been wise. I cannot argue with that, so maintaining a hold rating until seeing the new products is completely understandable if you did not want to put your neck out.

What I cannot understand is a sell rating on a company whose stock price is implying bankruptcy even though the company is getting private equity investments and you know that a highly respected former Apple exec has been leading a new R&D team for over a year. Are we supposed to act surprised that the Palm Pre looks promising? You may not have wanted to bet on it sight unseen, which is fine, but you can’t say that what Palm introduced yesterday was surprising given what we already knew was happening over there.

As usual, Wall Street hated the stock at $1, $2, or $3 but likes it a lot more at $6. Now you know why I like to be a contrarian.

Full Disclosure: Peridot was long Palm shares at the time of writing but positions may change at any time

Citigroup: A Sell At $3.00?

I really thought we would finally see a less negative view on Citigroup (C) from Meredith Whitney a couple weeks back when the stock hit three bucks. Whitney, you may recall, is the Oppenheimer & Co banking analyst who downgraded Citigroup to “underperform” last year when the shares traded for around $40 each. Last month, Citigroup hit a fresh intra-day low of $3.05, capping a stunning 13 month 92% drop in the shares of what once was one of the most valuable U.S. companies.

What a perfect time that was to remove a “sell” rating. At $3.05, Citigroup stock likely had two possible long term outcomes; go bust or go a lot higher. Whitney could have closed the book on what would have been one of the best analyst calls of all time. It would be easy to justify upgrading Citi to “neutral” at $3 per share. After all, after a 92% drop, the risk-reward trade off is far less compelling unless you really think the company won’t survive. Whitney has never indicated she thinks Citigroup will go under, so I have to think recommending investors sell the stock at $3 makes little sense, unless she wants to remain the most bearish analyst on Wall Street and an upgrade of a large bank stock wouldn’t fit that mold.

In the past two weeks, Citigroup stock has surged by more than 150% from the ridiculously low $3 quote to $7.70 per share as I write this. If that $3 print turns out to be the low (I am not predicting that necessarily, as I have no idea where bank stocks could trade in the short term), Whitney might have to remove her “underperform” rating at much higher prices, which tarnishes the call because she would have that rating on the stock as it doubled, tripled, or even quadrupled in value.

If the stock goes back down in the coming weeks or months, I think Whitney would be well-served to put a neutral rating on the stock, claim victory, and cement her Citigroup call as perhaps the best sell side recommendation of all time.

It would not be an easy decision given the banking sector still has not overcome its problems, but moving on would signal to investors and her clients that she has not resorted to simply being the most bearish banking analyst on Wall Street. Just because that is what put her on the map, it does not mean staying bearish for too long could not take her off of it just as quickly.

Full Disclosure: No position in Citigroup at the time of writing, but positions may change at any time

Sorry Fortune, Meredith Whitney Is Just An Average Analyst (You Even Said It Yourself!)

Remember when Henry Blodget made his $400 call on Amazon stock back in the late 1990’s? He will be known forever for that call more than all the other ones he made combined. Fast forward nearly a decade and Oppenheimer banking analyst Meredith Whitney has achieved similar rock star status. The August 18th issue of Fortune Magazine has her on the cover.

Now, I like Fortune a lot. In fact, aside from an online subscription to the Wall Street Journal, my subscription to Fortune is the only periodical I actually pay for. But this Meredith Whitney hoopla is really getting old, and quite frankly, it’s too much.

Like Blodget, whose $400 price target came to fruition despite the controversy surrounding it, Whitney’s early warning on Citigroup (C) stock last year definitely deserves kudos. She got death threats after suggesting the banking giant would be forced to cut their dividend and raise capital. At the time it was a minority opinion, but she was right and deserves credit for a very bold and correct call.

That said, let’s not get carried away. Investors and the media should not judge an analyst on a single call, but rather the entirety of their work. There are great analysts out there, but the track records of most are mediocre at best. When I have the chance to guest lecture undergraduate and MBA students, I often refer to a study that showed the stock picks of sell-side analysts, like Whitney, consistently underperform the market and do so with more volatility.

So, does Meredith Whitney deserve all the attention she has been getting lately from investors and the media (she is on CNBC all the time)? I have nothing against her, but I doubt it. She should be commended for the Citigroup call, but treating her as the “go-to” analyst on banks would only be reasonable if her track record beyond that one call was overly impressive. Unfortunately for investors, it isn’t.

In the Fortune cover story, in fact, it is mentioned that according to Starmine (a company that tracks the performance of analyst recommendations against their industry peers), Whitney’s stock picking ranked 1,205th out of 1,919 analysts in 2007 (the year of the Citi call). During the first half of 2008, Whitney’s picks ranked 919th out of 1,917 analysts.

The only conclusion I can draw from those numbers is that Whitney is no better than an average bank analyst. In the world of sell-side research, “average” is hardly something to get excited about.

Does this mean you should completely ignore what Whitney and other analysts say? No. They put in long hours and often can provide a lot of information that is helpful in conducting stock research. Still, we should not drop everything and hang on every word whenever Whitney is on CNBC or lands on the cover story of a magazine. She just isn’t going to make us rich.

Need proof? Consider her recent downgrade of Wachovia (WB). Whitney downgraded the stock on July 15th from “market perform” to “underperform.” For those who prefer to translate Wall Street lingo, that means she went from a “hold” to a “sell.” Good call? Umm, hardly.

Wachovia stock actually bottomed that same day at $7.80 and closed at $9.08 per share. It never traded lower than that, completely reversed course, and traded as high as $19.48 on August 1st. That is a gain of 150%, peak to trough, in just 13 trading sessions! Just imagine if you shorted Wachovia because Whitney put a sell on it!


Just as we should not judge Whitney solely on her Citigroup call, we also should not judge her solely on the terrible Wachovia downgrade. Still, since her stock picks rank her as an “average” analyst within a mediocre group of stock pickers, I can safely say the attention she is getting these days is a little over the top.

I still love Fortune and CNBC and all the other outlets going gaga over Meredith Whitney. I just think she’s pretty overrated and want people to understand the facts along with the hype. People just love a good story on Wall Street and right now, she’s it.

Full Disclosure: No position in Citigroup or Wachovia, long a subscription to Fortune at the time of writing

Merrill Lynch Somehow Cuts Target Price on GM by 75% in 1 Day

Academic studies have found that Wall Street analyst stock recommendations trail the market and do so with more volatility. As a result, investors who use sell side research should be careful to pay attention to certain data points that analysts have spent hours putting together, but to completely ignore price targets and ratings and instead coming up with their own opinion on the ultimate value of a stock.

The latest example that illustrates this point is the call we got out of Merrill Lynch today. ML’s auto analyst downgraded shares of General Motors (GM) from “buy” to “sell” and slashed the price target from $28 to $7 per share. That’s right, this analyst thinks GM is worth 75% less than it was 24 hours ago.

As for how to value GM, I think it is simply too difficult to do so. It is nearly impossible to estimate future legacy costs, and trying to figure out what a reasonable profit margin on cars should be is simply a guess because they are not even making money at all and their competitive position has deteriorated since they were last in the black.

Besides, if an analyst can tweak their model and get $28 one day and $7 the next, that is a pretty clear signal to me that valuing GM right now is just not something anyone can do with a large degree of confidence.

Anybody think GM is a buy at 10 bucks? If so, why?

Full Disclosure: No position in GM at the time of writing

Prudential Shuts Down Research Department

>One of the themes I have written about on this blog is the worthlessness of most sell side equity research. Most firms use their research departments to push stocks they have underwritten, and most investors understand that and discount their opinions as a result. Prudential (PRU) didn’t believe in that model, and they were right. They decided a while back to put their equity research group out on its own, not joined at the hip with investment banking. I’m sure the thinking was that their research will carry more weight since it is unbiased, and therefore will be a valuable product.

We learned Wednesday that Prudential has shut down its equity research, sales and trading business known as Prudential Equity Group. This move speaks much more loudly than my comments ever could regarding the value (or lack thereof) of analyst research. If the product was valuable, people would buy it and it would make a profit. The fact that sell side research is given away for free to clients should tell you just how valuable it is.

I really do think it is that simple. The last study I read showed that analyst recommendations not only trailed the returns of the S&P 500 index, but did so with more volatility. Hardly a ringing endorsement. Expect other research departments to be shut down now that someone got the ball rolling by being the first.

Full Disclosure: No position in PRU at the time of writing

Morningstar Analysts Seem Confused

I’ll gladly send a complimentary Peridot Capital 2007 Select List to the first person who can explain how this graphic from the Wall Street Journal Online (“When Buying a Stock, Plan Your Goodbye” – 01/14/07) makes sense. Put another way, how can Morningstar analysts justify calculating the fair value of a stock and then recommend investors not sell the shares when they reach that level?

Which Group of Analysts Will Be Right About Earnings?

Glancing over earnings estimates for the duration of this year and 2007, I noticed a very interesting dichotomy. Bottom-up analysts are still quite bullish on corporate profits, forecasting year-over-year growth in each of the four calendar quarters during 2007. Top-down analysts, conversely, are predicting annual declines in earnings beginning in Q3.

Which group will be correct? It’s simply too early to know. I would tend to side more with bottom-up analysts in general, merely because they are basing their forecasts on what actual company management teams are saying, as opposed to merely taking a broad macroeconomic view of the world.

That said, I am worried that earnings growth will be difficult to maintain. Over the last couple of years a majority of the gain in S&P 500 earnings have come from the energy and materials sectors. As we head into next year, contributions from these groups could be minimal, if not negative. Commodity prices seemed to have peaked for the short term, and although I do think we are in the middle of a secular bull market in the group, there is no reason to think we could not see a breather in the run during 2007.

If energy and other commodity stocks find it difficult to grow earnings, other groups would have to see accelerating profit growth to make up the difference and continue to boom in corporate earnings. I can’t really see what areas would be up to the task.

What is the implication for stock prices going forward? Depending on what earnings number one uses for the S&P 500, we are currently trading between 15 times (operating) and 16.5 times (GAAP) 2007 earnings estimates. Market bulls suggest that P/E multiples should expand given the outlook for economic and earnings growth. However, if corporate profits begin to see year-over-year declines in the back half of 2007, such multiple expansion is unlikely.

With multiples staying flat or declining, and profits peaking, it would be hard to make the case that stock prices have a lot of room to run next year. Perhaps that is why the S&P 500 seems to be having trouble breaking past recent highs in the 1,390 area. As it stands right now, I don’t see the S&P breaking meaningfully above 1,400 in the short term until we have increaased confidence that a more bullish scenario could play out.