Tuesday, September 13, 2011

Analyst Price Targets, Upgrades, Downgrades, Are Useless

People love to have opinions. Some people are fortunate enough to get paid to give opinions. Most opinions are worth their weight in gold. Note that opinions don't weight anything. Frequently, you'll read an article about some financial firm that has changed their opinion. Bank XXX has upgraded / downgraded / gave new price target on stock YYY. They like to use fancy words like overweight or underweight or oversold. Then then love to tell that they're right. They get to do this pretty often.

The question is, can you make money off of their advice? My answer is
no. It's easy to give a price target or a direction without giving a time. You'll notice that almost all analysts will not give a deadline for their predictions. There's a good reason for this. It's because most of them don't have a clue. Since they don't give a deadline for their prediction, it increases their chances of being able to tell you that they were right, due to nothing other than fluctuations in the market.

Let's say an analyst tells you a stock will go up. That stock goes up 3% after a year. The market average goes up 5%. The analyst can tell you that he was right, and if you had followed his advice, you wouldn't have lost money. Did his pick beat the market? No. Will his pick beat the market? Check his previous picks and you might get an idea of your odds. Let's say a blue chip company is at $60 right now, and the company makes a pretty stable $3 per share every year. If the price target gets upgraded to $65, a small fluctuation in the market or just the passage the time alone will bring the price to $65. He can instantly tell you that he was right. At the same time, a separate analyst could have given a price target of $58. Fluctuations in the overall market could easily swing the price down to $58 before it later goes to $65. The 2nd analyst would have been quick to tell you that the stock hit the $58 target and that he was right.

How do you trade on information like this? How do you know which price target the stock will hit first? You can't. You shouldn't. If an analyst picks a direction or picks a price for the sake of giving an opinion, you should ignore it. Perhaps if the analyst tells you that stable and profitable company currently at $60 per share and earning $3 per share has maintained a consistent PE ratio, and doesn't pay dividends, and that he expects the price to be around $66 within 2 years, he would have more credibility. However, this is useless information that doesn't take much to figure out. When a company earns money, and doesn't pay a dividend, its retained earnings account increases. With the expectation that market value will eventually follow intrinsic value, it's easy to see how the stock price should eventually hit $66.

So what can you listen to? In general, you should stay away from all of these. Once in a while though, you might find a gem. An analyst might tell you that some recent event has caused the stock drop in an exaggerated manner. It may be a lawsuit where the loss in market value is much larger than the damage which the lawsuit can cause. It might be the housing crisis causing a drop in the price of your grocery store. Hey may mention that this unwarranted price movement has decreased the PE ratio, but the company is still expected to continue performing very close to normal. He might argue that price will eventually recover because the business has solid fundamentals and that you are likely to see larger than normal returns by buying at such a bargain price. The reasoning behind the opinion is valid, and the opinion wasn't given just for the sake of giving an opinion. Something like this might just be worth taking a closer look at.

No comments:

Post a Comment