How to Get the Most Out of Analyst Research

Wouldn't it be great if the brightest minds on Wall Street shared their insights into how and when and by how much stocks will move? That's what you might think is happening when you get a research report, especially when its author is a big-name analyst you've seen on TV.

But there's less here than meets the eye. For starters, while Wall Street research is written in English, it employs a special idiom designed not to offend the covered companies, whose investment-banking business does a lot more for Wall Street than the commissions generated by individuals. So, you need a translator.

Similarly, the timing of Wall Street analyst reports is an issue. Big institutional holders such as mutual funds, which generate millions for the firms, are the first to be alerted to changes in analyst recommendations. By the time retail customers get their hands on an analyst's research note, it's about as useful as a Y2K survival guide.

The Winners

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Don't take it personally, advises one fund manager: "I get information faster and I get better information," he says. "It's not because they like me, but because I have $30 billion to throw around."

However, individual investors should definitely pay attention to Wall Street research. Once they study the art of research interpretation, they can find some valuable information to use in picking and trading stocks.

What do you need to know to find those golden nuggets? First, you'll need to learn the lingo. Then you'll need to know when and where to look.

Cracking the Code

Analysts communicate their opinions in several ways. They issue ratings or recommendations, like buy, hold and sell. They make earnings estimates, for quarters and for full years. They set price targets -- where the analyst expects to see the stock by a given date, usually within 12 months. This type of information can be found in an analyst's written research reports, which are relatively lengthy documents about a stock or industry, and notes, which are short comments usually issued in reaction to news events.

To get the most out of a research report, you need to understand the terms. The words may be familiar, but the meanings are not. The terms vary slightly from firm to firm. Merrill Lynch's scale, in descending order, is buy, accumulate, neutral, reduce and sell. At Salomon Smith Barney, the ratings are buy, outperform, neutral, underperform and sell.

You cannot, however, read these literally.

"You have to look at it in relative terms," says Chuck Hill, director of research at First Call/Thomson Financial and a former analyst. "If an analyst is saying hold, that's a code word for sell. A buy is a hold." And, adds Stuart Teach, co-manager of the (HOVLX)Homestead Value fund, "When something is a long-term hold, that really means look elsewhere."

Also, bear in mind that there is a bias toward positive ratings. The vast majority fall into the top three categories. Typically, one-third of all ratings are strong buys. Another third are buys and one-third are neutrals. Less than 1% are actual sell ratings, according to First Call.

Right now, analyst recommendations are even more positive than usual. Of the more than 27,000 ratings tracked by First Call, 37.5% are strong buys and 37.1% are buys, while 24.7% are neutrals. That means that almost three-quarters of all analyst recommendations are telling you to buy and almost nobody will actually say sell.

Still, even if you understand the subtleties, these ratings are virtually worthless on their own.

Investors generally should not buy or sell a stock based solely on an analyst's recommendation or an upgrade or downgrade of that rating. Institutional investors don't care much about ratings.

"We only look to the analyst and the sell side for information, not their opinions," says Homestead's Teach. What's important, then, is to know what's behind the rating decision -- what the analyst is thinking about a company's future, and why.

Consider ratings changes. Very often, an analyst might downgrade a near-term rating because a stock's price has run up too quickly. On the other hand, an analyst might upgrade a stock for tactical reasons -- because a small piece of news, which has no bearing on the long-term prognosis, could give a stock a quick boost and the analyst doesn't want to appear to be behind the curve. If you're a long-term investor, the ratings changes that matter are those that are based on significant changes in a company's fortunes.

Estimating Those Earnings Estimates

Investors should bring the same skepticism to looking at an analyst's earnings estimates. You need to understand the usual patterns.

What's important to keep in mind is that the prediction for this quarter's earnings made with great confidence a year ago is subject to last-minute revision. Typically, when the actual results start to come into focus, analysts are likely to trim estimates so that they don't look wrong. They often do so with a little help from their friends at the companies they cover. "A company might try to jawbone the analysts down to make sure the company doesn't miss the consensus," says Hill.

The game can become even more complicated. Sometimes companies like to engineer positive earnings surprises by guiding analysts to lower estimates. The result: Consensus estimates often turn out to be a little low by the time a company reports.

You should also be wary when analysts are overly positive in their estimates. The optimism may not have anything to do with any improvement in a company's outlook, but instead may just be a way for the analyst to catch up with the market.

"I am always a little suspicious when analysts raise their earnings targets to justify runaway valuations on share price," says Bernard Picchi, director of U.S. equity research at Federated Investors and the former head of U.S. stock research at Lehman Brothers.

Mob Mentality

It's also critical for investors to remember that Wall Street analysts tend to move in unison.

As a group, they often change their opinions or earnings estimates after news comes out on a stock, whether it's a profit warning or the disclosure of dreaded accounting problems.

"A company comes out and cuts earnings and all the analysts follow suit and put out notes," says Hill. "What the hell good does that do anybody?"

Remember when Cendant (CD) blew up about two years ago?

Blinded by love for this one-time Wall Street darling, most of the analysts following the firm rushed to downgrade the stock only after the company revealed accounting problems.

Likewise, earlier this year, analysts were still upping ratings of Procter & Gamble up to the moment when the consumer goods giant issued a warning about problems that would create an earnings shortfall. The day that P&G revealed its problems, the stock fell 31.2%, and it hasn't recovered.

Why do so few analysts fight conventional wisdom? One obvious explanation is that they're getting most of their information from the same source: from the company itself, rather than by doing independent research with customers and competitors.

Independent Thinking

You want to look for the analysts who can and do think independently.

Yes, they do exist.

According to TheStreet.com's Analyst Rankings - Equity 2000 survey, analysts like Gunnar Miller who covers semiconductor equipment at Goldman Sachs, and Byron Callan, the aerospace and defense analyst at Merrill Lynch, get high marks for telling the truth.

Ivy Zelman, who covers building at Credit Suisse First Boston, and Rick Sherlund, the Microsoft and software analyst at Goldman, were recognized as well-connected analysts.

Written Reports

In an analyst's written research, you should look for evidence that the analyst is talking to a company's competitors, suppliers and customers. If you see that an analyst conducted a survey, "now you're getting into some really good stuff," says Hill.

And don't forget to look at the fine print first. Somewhere in the

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