There’s been a lot of tough talk about how “tainted” Wall Street stock research is — and what should be done about analyst recommendations influenced by investment-banking fees and other conflicts of interest. It’s an important question of business ethics, legal liability and government regulation, as I discussed in this column two weeks ago.
But all that aside, there’s actually a more interesting question about Wall Street research: Is it worth a damn? Like all really interesting questions, the answer is “yes and no.” But that’s only the beginning — once you understand the “yes” part and the “no” part, then you have to decide what to actually do about it.
Wall Street research can be very valuable in pure analysis, in helping investors understand the earnings dynamics of companies. But putting that analysis into action — either in an investment you decide to make based on it, or the analyst’s own Buy/Sell/Hold recommendation — is very tricky.
For example, on Thursday (Nov. 21) General Electric announced a dramatic decrease in its forecast earnings per share for 2002, thanks to its decision to take a $1.4 billion loss reserve in its Employers Reinsurance unit. Several Wall Street analysts — for example Merrill Lynch’s John Inch and Banc of America Securities’ Nicole Parent — predicted the charge, and correctly estimated its general magnitude. So no one can say that Wall Street was blindsided by the news — not all the analysts made this call, but some did. That’s the way it’s supposed to work: Some are better than others.
But now comes the tricky part. Suppose that among all the analysts you could have listened to, you decided to listen to Inch and Parent. Suppose you even knew for sure that they’d be right about the loss reserve. What would you have done? Would you have sold GE, expecting the stock to plummet when the bad news was officially revealed to the rest of the world? You’d be a big loser if you did. After the loss reserve was announced on Thursday, GE surged higher, closing up a stunning 8.27% on the day.
How many times has this happened to you? You were right on the analysis, but wrong on what to do with it. It’s the same with Wall Street research. The problem isn’t that Wall Street research isn’t correct — the problem is sorting through all the research and figuring out which research is correct, and figuring out what to do with that research.
Adding to these difficulties is the fact that research isn’t free. You pay for it one way or another. Maybe you pay for it directly, by subscribing to services like Trend Macrolytics. You certainly pay for it indirectly, both in the transaction costs you bear when you act on the research, and in the valuable time you take to filter all the research you’re exposed to and decide what to do with it.
So what’s an investor to do? For one thing, you should assume that any research that you see in any widely disseminated medium, including Wall Street research, is very quickly absorbed in the market and incorporated into stock prices. The most valuable research is the most proprietary — it’s the research that you come up with yourself, perhaps using publicly available research as a partial input. Of course, the ultimate proprietary research, the most valuable of all, is illegal — it’s called insider trading. So the idea is to get information that no one else has, but to stay out of jail.
To be proprietary, research doesn’t have to consist of facts that only you know. Instead it can consist of conclusions that only you draw from known facts. You want to look at what others have looked at, but see what others haven’t seen — that is my own philosophy at my research firm Trend Macrolytics. In the case of GE, it consisted of acknowledging that Inch and Parent were right, but also that GE was priced for an even worse worst-case scenario — and thus knowing that GE would rally when the bad news was finally revealed and quantified.
For investors who feel they can’t do that, the answer has often been to give up on research altogether and put their money in an index fund — a fund where you simply buy every single stock in an index such as the Standard & Poor’s 500. That is, of course, what Vanguard Group founder John Bogle recommended in a commentary in The Wall Street Journal last week — he’s been a skeptic on research for decades. But what Bogle doesn’t say is that index funds depend critically on research for their success.
How’s that again? How can index funds that use no research depend on research? Indexers base their strategy on the strong assumption that the market is efficient — otherwise they would be fools to blindly buy every stock in an index without performing any research. For the market to be efficient, someone must have made it so — by doing research! If no one did that research, markets wouldn’t be efficient, and it would make no sense to buy index funds.
Best of all, index funds get all that market efficiency for free. They don’t have to pay the high commissions that subsidize Wall Street research, or bear the risk of listening to the wrong research, or listening to the right research and making the wrong decision about it. They just sit back and let everyone else bear all those costs and risks. It’s a sweet deal, and it explains why index funds tend to beat most nonindexed funds over time.
So it’s slightly illogical for Bogle to dismiss Wall Street research in his commentary by repeating a common critique: “Of 6,000 recommendations made by Wall Street firms during 1999, according to one study, only eight recommended ‘sell.’”
I say that’s illogical because in the same commentary Bogle recommends, “…skip the research and buy an all-market index fund. Then hold it for Warren Buffett’s favorite holding period: Forever.” In other words, listen to the Wall Street analysts, but listen to all of them all at once: Buy everything.
But whatever you do, be sure to say thank you. Whatever you may think about the honesty and the usefulness of Wall Street research, it’s keeping markets efficient for all of us.
First appeared in SmartMoney.com