Analyst Advice: Bad Enough to Profit From

Updated from 6:58 a.m. EDT

When Merrill Lynch analyst Joseph Osha downgraded Intel ( INTC) to neutral from buy on Monday, some people thought it was a contrary indicator -- that is, a good reason to buy the stock.

The 10% drop in the stock Wednesday affirmed the call, but notwithstanding his current prescience, critics say Osha's track record leaves a lot to be desired. During 2003, for example, he held a neutral rating on Intel for about four-and-a-half months, during which time the stock rose about 40%.

Going further back to January 2002, Osha slapped a strong buy rating on Intel when it was sitting at $33.52. By early June of that year, the stock had fallen 17% whereupon he down-graded it to neutral. Intel then fell another 32% before Osha advised investors to sell in November.

Since July of last year, the analyst has done a little better. From the time he upgraded the stock to buy in July 2003 until the time he downgraded it to neutral recently, Intel gained about 14%. Still, the stock had already fallen 23% from January, prompting some investors to question whether Osha's call was too late. He, for one, stands by his record.

"I have now, three years in a row, changed my rating in the correct direction in front of negative or positive surprises," Osha said.

Whether or not the criticism is fair -- certainly other analysts have had an equally bad, if not worse, record -- it does provoke an interesting question: How would investors do if they bought when most analysts were advising to sell and sold when analysts started cheerleading?

According to a recent study by Smith Barney equity strategist Tobias Levkovich, such a strategy might make sense. He compared the "most loved" stocks on Wall Street, or those stocks where the average rating among analysts is a buy, with the "most hated" stocks, or those where the average rating is a sell. The ratings data is derived from a poll of analysts surveyed by Thomson First Call.

Levkovich's conclusion was that the "hated" group typically outperformed the "loved" group over six- and 12-month periods from the first quarter of 2000 through the second quarter of 2003.

The favored stocks rose just 2.8% on average after six months and 3.7% after 12 months, while the other group gained 11.98% on average after six months and 21.4% after 12 months.

The fact that an analyst produced this research is unusual in itself. Typically, indictments of the analyst community come from the academic world. Levkovich did defend his profession, saying the results reflect "the potential for surprises that change consensus views." It's not that analysts haven't done their due diligence, he argues, but that unforeseen events often take over.

"For instance ... if investors perceived an upbeat future and then a competitor offered a similar product or service, thereby knocking down the P/E multiple, the stock would suffer even though the earnings numbers still look quite healthy," he said.

Whatever the reason, Levkovich's data show that it would have paid to do the opposite of whatever analysts were suggesting over the past few years.

A screen for some of the "most loved" stocks today pulled up names like 3M ( MMM), Allied Waste ( AW), Avaya ( AV), Dell ( DELL), E*Trade ( ET), Fannie Mae ( FNM) and General Electric ( GE).

In the "hated" group are stocks like Ciena ( CIEN), Albertson's ( ABS), Campbell Soup ( CPB), Eastman Kodak ( EK), Bristol-Myers Squibb ( BMY) and Archer Daniels ( ADM).

Before you think about developing a contrarian strategy, however, there are some things you should bear in mind. First, Levkovich's study is fairly limited because it covers just the last three years, and those years could be considered unusual because of the huge boom and bust that took place.

In addition, Levkovich points out that while an equally weighted "hated" group "more often than not" beat the equally weighted "loved" group, "individual stocks within these groups could have a very different performance."

"Thus, cherry picking from these lists could prove disastrous to one's portfolio's health," he said. What's more, buying and selling stocks regularly based on analysts' recommendations will mean higher transaction costs, which can eat into returns. Still, the data confirm that it's important to be wary about analysts' buy and sell calls.

Academic studies have long suggested that purchasing buy-rated stocks and selling sell-rated issues might not be the best strategy for investors. A recent paper by professors Leslie Boni of the University of New Mexico and Kent Womack of the Tuck School of Business at Dartmouth found that a long-short portfolio of stocks based on the consensus level of buy and sell ratings was flat in the next calendar month, not including transaction costs. The study examined stocks from 1996 to 2002.

"The ... investor has little to gain from observing a stock's consensus level, which is likely to incorporate recommendations that have been issued many months prior," the professors wrote.

They argue, however, that if investors followed the net change in upgrades and downgrades, i.e., the switch from a neutral to buy or buy to sell, rather than just the consensus rating at a static point, returns might improve.

"Buying the firms net upgraded by analysts and shorting companies that are net downgraded each calendar month yields 1.4% in the next calendar month, or about 17% annualized," they wrote.

Once again, however, the professors noted that these returns do not include transaction costs. While analysts can certainly provide valuable information and insight on a range of stocks and industries, it's not clear that investors can beat the market over the long term by following their advice.

"The historical evidence suggests that being part of the consensus is generally not the most gratifying method for making money on Wall Street," Levkovich said.

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