BULLS & BEARS: Beware recommendations from Wall Street analysts

August 14, 2006

Should you rely on buy and sell recommendations issued by Wall Street analysts to assist you in your investment decisionmaking? My answer would be no.

To use analyst ratings, the first hurdle you must overcome is deciphering the lingo that often is used in place of three simple words: buy, sell or hold.

For example, you need to know what market-neutral, underweight or-my personal favorite-sector outperform means. You also would need to distinguish between moderate buy vs. strong buy.

But my biggest beef with analyst buysell recommendations is that, all too often, analysts downgrade stocks after they have dropped significantly in price, and upgrade them when they have risen markedly in price.

This sell low, buy high approach is not a recipe for producing attractive investment returns. Consider the analyst downgrades that took place this past week after Emmis Communications Corp. CEO Jeff Smulyan dropped his $15.25-per-share offer to take the company private.

Two analysts downgraded the stock-naturally, the day after the announcement. One of the downgrades was to peer-perform from outperform.

If you interpret that as a sell signal, you would have been selling Emmis' stock in the mid-$11-per-share range that day, or some 20 percent lower than the prior day's closing price of about $14.50.

What's more perplexing is that the analyst noted in his memo that he believed Smulyan would most likely have raised his offer to $17.50 a share, but surmised that the special committee to Emmis' board was demanding more than $20 per share.

Why downgrade a stock, and advise investors to sell at $11.50, when you think insiders presumably believe the stock is worth $17 a share to $20 per share? Instead, wouldn't this reasoning actually warrant a buy recommendation?

That 20-percent drop shaved $100 million off the price of Emmis in one day. I would suggest that when something becomes $100 million cheaper overnight, it is probably more worthy of consideration for purchase than for sale.

In fact, the universal dislike of the radio industry by Wall Street is enough to consider a look into radio stocks. If the investment case on Emmis can be made, and if it took four "long" years for the stock to climb to $18.50, an investor would realize more than a 12-percent annual rate of return.

So when it comes to Wall Street research, investors may find some factual material in the reports useful, such as the industry analysis and financial comparisons of a particular company to its competitors.

But skip the buy-sell rating and the projections and forecasts that fill pages of these reports. Value Line (available free at most libraries) is a nice, concise source of data, but here again, ignore its rating system-we find that we are usually buying stocks that are rated low by their service at the time of our purchases.

In the end, armed with SEC filings on companies (easily obtained over the Internet) and perhaps the data from a Value Line sheet, the investor really has everything he needs to make informed-and independent-investment decisions.

Therefore, don't fret if a stock you find attractive has recently been downgraded by Wall Street analysts. It actually might be a good time to buy.

Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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