Wall Street research is useful . . . from a contrary perspective

I have been observing Wall Street "sell-side" research for many years now. Frankly, I find it is predominately useful from a contrarian perspective. This past Monday (Oct. 27), a Goldman Sachs (GS) research opinion hit the wires and provided, in my opinion, a classic example of the short term, myopic mentality that is prevalent in the Wall Street brokerage community. So, I thought I'd share.

Analysts who work for Wall Street brokerage houses are called "sell-side" analysts.  They sell their research to the "buy side" i.e., asset managers, mutual funds, pension funds, etc., in exchange for directed trading (commission revenue) through their respective firm's trading desks. While there are plenty of smart analysts who work on the sell side, one criticism of the sell side is that access to management is often more important than forecasting accuracy. In fact, there are very few "sell" ratings on covered companies on the sell side because analysts don't want to get "black listed" by company management.

This is also why you have various "soft" ratings system on the sell side. For example, a sell side analyst might downgrade a company from "buy" to "neutral" or "overweight" to "market weight." Outright "sell" recommendations are very rare and usually happen prior to the broker dropping coverage on a stock all together.  

They also have "price targets" which are typically derived from forecasts of earnings and price-earnings multiples, which are estimates of what investors might be willing to pay for $1 of a company's earnings. Intrinsic value, derived through the assessment of the worth of a business based on discounted cash flow analysis, is virtually unheard of on the sell side. We prefer discounted cash flow analysis because of its longer term modeling, and management cannot manipulate cash flow as easily as earnings.

Foresight or hindsight?

Monday, an analyst at GS issued a forecast for crude oil of $74 per barrel and downgraded nearly every energy company he covers. This caused energy stocks, which rallied nicely the prior week, to sell off yesterday. Fifteen energy companies were almost all downgraded from "Buy" to "Neutral" and price targets were slashed across the board. Only one company was deemed a "sell."

The only company on the list we have purchased for our clients was Halliburton (HAL). It was removed from the firm's "Conviction List" but maintained a "Buy" rating with a price target lowered to $65 from $87. The stock closed at $55.70 Monday. We believe its previous target was way too high based on a longer term discounted cash flow projection using normalized, conservative energy prices, and its new target is moderately too low.

My main problem with this forecast and downgrade is that it would have been much more useful to an investor a month ago than Monday. The market began to price in the prospects of a near term oil glut more than a month ago. The new price targets of the covered GS energy companies are much closer to their respective 52-week lows than 52-week highs!  When the stock of a viable company generating cash flows goes down, its long term expected return increases.   

Certainly, more downgrades from the sell side are possible, and we may not have seen the bottom yet for the energy sector. But sell side downgrades based on short term outlooks, to us, are contrary indicators and create opportunities to examine companies more closely for purchase, not sale.

Dana L. Crosby, CFA, CFP®