Analyzing the Analysts

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In our recent series on profiting from stock earnings news, we took a look at how stock analysts’ forecasts are aggregated into the earnings estimates that stand so fundamental to market expectations. In the coming weeks, we’ll analyze another powerful source of profitable data generated by these analysts: their actual price targets for individual stocks.

But before we explore this area, we need to answer a more basic question. Who are these “analysts” anyway, and why are their predictions worth listening to? First, we should note that there’s no exact science when it comes to investing: not one of these analysts knows where a price should or will be. Even if the analyst in question is “right” at some fundamental level, scientifically predicting a stock’s price would mean knowing precisely how millions of other investors will react. Even the best stock pickers miss on predictions all the time. Remember, winning even a relatively slim majority of stock picks can lead to market-beating profits.

Who do Analysts Work For?

There is not a set professional background for securities analysts. Like many skilled professionals in finance, many come from an MBA, CPA, or even JD academic track. Many sectors, meanwhile, demand specific expertise. In areas like pharma, energy, or tech, the relevant analysts are just as likely to have a background related to operational details as in more traditional finance.

It’s helpful to sort these analysts into two broad categories based on the function they play in markets overall. These functions shape the motivations analysts face when evaluating firms.

First, we have the “Sell Side” analysts, typically employed by investment banks or stock brokerages. When a firm wants to issue stock (typically as an IPO, but possibly some variety of supplementary offering), they seek out a bank to underwrite that effort. As part of the underwriting process, the bank has to decide a price point for the stock (whether it’s a public or private issuance). Vitally, this stock will be priced to sell, although the bank will also be seeking to maximize returns for itself and its client. Their compensation is typically based on transaction-based fees paid by the issuing company.  This group also includes most analysts working for brokerages, who are compensated based on their ability to convince investors to buy more stocks.

“Buy Side” analysts, meanwhile, tend to work for institutions that are large net purchasers of stock, like mutual funds, pension funds, or hedge funds. Buy-side analysts are typically compensated through direct employment by a fund.

Since sell-side analysts often have close professionals ties to the firms they’re covering, they’re more traditionally associated with questionable analytical motives. The buy-side, however, can also be a source of disingenuous evaluations, as analysts seek to propagate opinions that help their own holdings.

A healthy skepticism should always reign when investing, but important changes in the last 20 years have forced analysts always from the most blatantly dishonest practices.

Trust and Verify: Bringing Data to Bear on the Analysts

As recently as the 1990’s, analysts faced far fewer regulations concerning conflicts of interest between their stock rating and clients. Failures stemming from these conflicts of interest, however, are partially responsible for the surge of corporate fraud from this era, exemplified by firms like Enron and Worldcom. Analysts simply weren’t conducting the sort of due diligence they claimed to be.

The Sarbanes-Oxley Act from 2002 put a stop to the worst of these behaviors, requiring internal structures separating, for instance, sell-side analysts from the department conducting actual security issues.

But, rather than rely on regulators to enforce perfectly fair information from all analysts, News Quantified has a different approach: use data to put analysts’ ratings to the test. Our platform features deep data on market reactions from past stock ratings for a huge selection of market-moving financial analysts. We’ll be exploring the strategies enabled by this data further in the coming weeks. If you’d like to learn more about how our data-rich platform is helping smaller investors beat big funds at their own game, we highly recommend one of our totally free training sessions. Just claim a spot in our next session using the button below:

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