Analysts Continue to Boggle the Mind

There are 3,400 sell-side research analysts in the United States. No matter what they do, they’re not going to get too many flattering comments from me on this blog. First off, don’t get me wrong, there are some good analysts out there. They are tough to find, and likely only number in the dozens, but they do exist. But for the vast majority, they baffle me. Let me explain two extremes.

First, we have Sears Holdings (SHLD), one of the largest retailers in the country with more than 3,000 stores and $50 billion in annual sales. Guess how many analysts cover SHLD? (Hint: take the “under”). The answer is 6. That compares with 23 for Target (TGT), 24 for Wal-Mart (WMT), 28 for Bed Bath & Beyond (BBBY), and 29 for Best Buy (BBY). How can this be? The sell-side is not shy about telling you that it’s because Sears doesn’t give guidance.

Without guidance, how can they possibly know how to project sales and earnings on a quarterly basis! It’s ludicrous, really. After all, a research analyst’s job is to research, analyze, and make projections. Heaven forbid should they actually be forced to do their job! So what we have on Wall Street are people who take numbers companies give out on conference calls and plug them into their own Excel spreadsheets. Not exactly quality due diligence.

But then we have the other end of the spectrum. It occurs a lot less frequently, but it does happen, as Wednesday’s trading action in Cigna (CI) stock shows. Cigna shares fell $15 after reporting first quarter earnings. What happened, you ask? They missed estimates, right? Nope, they reported EPS of $2.11 on $4.1 billion in revenue. Consensus estimates were $1.89 and $4.1 billion.

Oh, well then they lowered guidance for 2006, right? Wrong again. Cigna actually raised 2006 EPS guidance from $7.25-$7.70 to $7.50-$8.00 per share. Well then why on earth did the stock drop $15? Amazingly, it was because analysts had been projecting 2006 earnings of $8.07 per share (estimates ranged from $7.50 to $9.10). Why would the average Wall Street projection be for EPS of more than $8.00 when the company ‘s management thinks they are going to earn less than $7.50?

As stated before, I’m all for analysts doing extra work on their own outside of conference calls and press releases from companies. However, when a stock drops $15 after the company raises their guidance for the year, something isn’t right. Such a huge discrepancy between what management teams project and what analysts project should be a red flag. If the analysts are more accurate, then they are doing their job well, but such instances are rare. After all, CEO’s and CFO’s should certainly know more about their company than the analysts who cover them.

Now for the only really important question with respect to all of this: is Cigna a buy at $90 after the $15 drop?

Analyzing Gradient Analytics

Surely you’ve heard of Gradient Analytics by now, as it’s all the Wall Street media outlets have been talking about lately. In case not though, let’s recap. Gradient is a research firm based in Scottsdale, Arizona. They focus on forensic accounting analysis of public companies.

The latest issue that has been getting all the attention has to do with negative reports Gradient issued on Biovail (BVF), a poorly run Canadian drug company. Biovail is suing Gradient claiming their inaccurate and misleading reports caused a 50 percent drop in BVF stock during 2003 and 2004. News broke that Steve Cohen, hedge fund manager at SAC Capital and Gradient customer, actually requested a report from Gradient that focused on negative aspects of Biovail’s business. SAC was interested in shorting Biovail shares, or perhaps they already were short at the time of request. Gradient did produce a report, and subsequently distributed it to the rest of its customers.

On the surface, this kind of thing looks very suspicious. If SAC Capital was short BVF and asked Gradient to write a negative report on it so they could profit from their short position, it certainly appears that so-called “independent” research is far from independent. Even still, a Gradient report is not responsible for a 50 percent drop in BVF stock, as the company contends. The company’s financial results account for the drop.

In response to the lawsuit, Gradient has said that SAC was requesting a follow-up to a previous report it published about Biovail on its own. If that is true, and SAC was not ghost-writing these reports with false information (as some are contending), then it is hard to reach the conclusion that any law was broken. Unless Gradient and/or SAC knowingly disseminated false information in order to profit from existing short positions, this issue seems to be blowing way out of proportion.

Most are screaming for disclosure of these types of relationships. As a result, Gradient should add some fine print at the end of its reports saying that they might have been published based on a client’s request, not because it was the research firm’s original idea. I have no problem with such disclosures, but don’t think for a second that it will change anything.

Sell side research now discloses how many buy, sell, and hold ratings they have on all of their investment banking clients, but we still see mostly buy ratings on stocks of banking clients. I recently read a report from a boutique firm specializing in healthcare stocks. They had a buy rating on the small cap biotech company I was reading about. In fact, at the end of the report they disclosed that their research analysts cover 11 companies with whom their firm has a banking relationship. All 11 stocks are rated “buy”.

How much stock should investors put on Gradient’s research anyway? Last week shares of Rackable Systems (RACK) dropped 6 bucks temporarily after Gradient’s computer model spit out a negative red flag about increasing inventories. They postulated this was a sign of poor earnings quality.

Unfortunately for Gradient’s clients, the computer program wasn’t able to research Rackable’s business model. Had it done that it would have learned that Rackable, much like Dell (DELL), builds product only after it is ordered. So, all of its inventory has already been sold, thereby making increasing inventory levels a signal of stength in the business, not the opposite as Gradient concluded.

Analyst Costs Sherwin Williams Investors

If you read this blog regularly you know that I don’t listen to sell side research analysts. Upon hearing this I often get strange looks from prospective clients until I explain why. It’s pretty straight forward actually; analyst stock picks won’t make you any more money than a monkey will throwing darts at the Wall Street Journal stock tables.

Today’s example comes to us from Eric Bosshard, the FTN Midwest research analyst who covers Sherwin Williams (SHW). Collectively, Wall Street analysts were fairly bullish on Sherwin Williams coming into February. Of 9 analysts who follow the company there were 6 buy ratings, 3 holds, and no sells. Shares of SHW closed February 1st at $54 per share.

Last week, SHW and other paint makers lost a lawsuit claiming public nuisance for selling lead paint in Rhode Island in the 1970’s. Shares of SHW tumbled to as low as $37.40 last Thursday, before rebounding to close at $45.55 yesterday. As the stock fell from $54 to $37, nobody upgraded the stock to “buy”. Now we can say the lawsuit uncertainty prevented them from recommending the stock, but very few people could make the case that a public nuisance verdict against SHW should cost the company 31% of its market value in a single day.

There was one analyst who changed his rating. Eric Bosshard of FTN Midwest pulled his “buy” rating on Thursday morning. As you can see from the chart below, his call marked the bottom, and it quickly rebounded more than 20 percent in a matter of days. I don’t want to even think about how many people sold Thursday morning after his call.

This type of story plays out all too often on Wall Street. What’s worse is what will likely happen from here. Afraid of looking like an idiot, Bosshard will probably keep his “hold” rating, hoping for further downside that will vindicate his call. The stock will continue to rise and eventually get all the way back to its old highs. With the problems in the past, he’ll recommend the stock citing “diminished uncertainty surrounding the Rhode Island verdict”. FTN Midwest clients will have bought high and sold low.

Perhaps what’s most striking about this story is the fact that on the very day that FTN downgraded the stock, Sherwin Williams insiders, including Chairman and CEO Christopher Connor, were buying shares in the open market. Pretty ironic if you ask me.

Wall Street Research Still Screams “Buy”

Ever since New York AG Eliot Spitzer began his crusade to separate Wall Street’s research and investment banking divisions, investors have been told equity recommendations would become more valuable. No longer would most stocks be slapped with “buy” ratings (or the ridiculous 1999 favorite “strong buy” rating). Whereas a “sell” rating in the 1990’s could get an analyst fired, now such calls would become more common.

Well, you can throw all of that out the window. A.G. Edwards (AGE), a mid-sized investment bank, isn’t even known for its relatively small investment banking division, so one would think their research would be more “valuable” than some competitors. However, a glance at their current ratings distribution is quite disturbing.

AG’s research analyst team covers 689 companies. Of these, 70, or about 10% percent, have hired the company as an investment banker in the last 12 months. Astonishingly, only 17 of the 689 stocks covered had “sell” ratings as of August 8th. That’s only 2 percent! The natural follow-up question would be, “How many of those 17 negative recommendations are also one of the 70 investment banking clients?” The answer is “not a single one.”

Brilliant Brokerage Call of the Day

A few years back, Prudential Securities got out of the investment banking business. It was widely expected that without the typical conflicts of interest that other diversified investment companies faced, Pru’s research department would be less biased, and therefore produce more valuable recommendations for their clients.

So much for valuable research. Prudential lifted its view on the energy sector to overweight today, and slapped a buy rating on shares of ExxonMobil (it was rated neutral before). Evidently their energy analysts see something fundamentally favorable to the big oil stocks, as of this morning. I’m sure Pru’s clients are thrilled with such a timely call.