What stock analysts are good for.

How to understand Wall Street.
Oct. 1 2004 11:49 AM

What Stock Analysts Are Good For

A lot—but not picking stocks.

Read Henry Blodget's detailed disclosure statement here. To read previous installments in the Complete Guide to Wall Street Self-Defense, click here.

In previous installments of this series, I have argued that most stock-market success is the result of luck and that few forecasting tools can reliably predict what the market (or any particular stock) is going to do. I have also observed that the vast majority of professional investors underperform the market and that, therefore, the best strategy for most people is to invest in low-cost index funds.

If this is so, then what the heck are stock analysts for? Why are thousands of analysts being paid zillions of dollars to do work that, on average, apparently isn't worth the cost of the chairs the analysts sit on?

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The answer is complex. First, it turns out that stock analysts are valuable—sometimes very valuable—but not in the way that most of the public and financial press think. Specifically, casual observers view analysts simply as "stock-pickers," when stock-picking is often one of the least helpful services they provide. An analyst's goal is to help investors make decisions, a mission that encompasses not only rating stocks, but also providing industry expertise, trend-spotting, evaluating scuttlebutt and gossip, interviewing management and customers, and shaping mountains of raw data into coherent projections.

To understand the value unrelated to stock-picking that an analyst can provide, it helps to look at a few examples. Back in the dot-com days, for instance, when grocery-delivery company Webvan was going to revolutionize food shopping, the company's executives assured investors that their trucks could make four to six deliveries an hour. This seemed plausible—until an analyst named Mark Rowen rented a car, followed a few trucks around, and reported that, with Bay Area traffic, they could only make two to threeper hour (one of the many reasons the company went bust). The same year, when hedge funds were salivating for insight into Amazon's performance in the critical holiday season, an analyst named Jamie Kiggen temporarily traded his suit for a temp job at one of the company's distribution centers. After loading thousands of packages onto conveyor belts, he quit moonlighting, took the train back to Wall Street, and reported that morale was high and business strong. When you're managing hundreds of stock positions—or trading from home—you don't have time to hit the road to see whether management is full of it. If you read Rowen and Kiggen's research, you didn't have to.

A more mundane example: Earlier this year, before Google filed documents in preparation for its IPO, investors were bursting with questions: How did Google's financial performance compare with other Internet leaders? How much money could the company make? What might the stock be worth? With most analysts muzzled by regulatory restrictions—a silly rule that prohibits analysts at IPO underwriters from saying anything publicly about the stock until 40 days after the offering—an analyst named Mark Mahaney at an independent "boutique" called American Technology Research filled the void. Less than 24 hours after the company filed its first set of papers—and without making any form of stock recommendation—Mahaney published a report assessing Google's potential value and performance and set out some preliminary earnings estimates. Mahaney's analysis wasn't genius, but it was the right product at the right time. He gave investors a starting point, a benchmark against which they could compare their own Google ideas.

Following an industry consists mainly of grunt work: scrutinizing financial filings, spending hours with company managers to understand business subtleties or quirks in the financial statements, interviewing vendors and customers, tracking industry data, attending conferences, talking to investors and industry experts, tweaking financial forecasts—all with the aim of spotting any hint of a change in trend. Most investors follow multiple industries and hundreds of stocks, so the time they can devote to tracking a single industry is limited. If nothing else, therefore, a strong sector analyst can save them time.

The work of a great analyst, of course, will go beyond this. A great analyst will not only gather, organize, and assess relevant information and trends, but will also make bold, provocative arguments that challenge the conventional view of an industry or stock. Doing this is risky—the analyst will be unpopular (initially), and his or her reputation will be on the line—but it is the most valuable service an analyst can provide. Even if wrong, such arguments can force investors to confront ideas and data they might have failed to consider. While taking such stands does involve making stock predictions ("Everyone loves Google: Here's why they will lose their shirts"), it is not "stock-picking," per se. The analyst is not surveying 7,000 stocks to find the winners, or even trying to find the one stock in an industry that will make investors the most money. Instead, the analyst is attacking a consensus position and possibly upending it, thus improving the efficiency of the market overall.

Which brings us back to the original question: If, despite all these efforts, the market is so hard to beat, why have analysts at all? The simple answer—a tautological one—is that as long as there are investors who try to beat the market, there will be analysts who, one way or another, try to help them. The more profound answer is that one of the reasons the market is so hard to beat, even for professionals, is that, in aggregate, analysts and investors are good at what they do (evaluating, distributing, wringing the profit out of every piece of information). After an 18-year bull market, of course, the number of analysts has ballooned beyond what is needed to get the job done—the world probably doesn't need 24 analysts covering Microsoft, for example—but Wall Street is nothing if not laser-focused on the bottom line. Over time, if the market stays stagnant, many analysts will eventually be exploring other professions. But there will always be Wall Street jobs for the best of them.

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