Tuesday, May 14th, 2013
the best analysts

Last week, the Wall Street Journal published its annual “Best on the Street” survey.Wall Street Journal | This page has links to the various stories and rankings from the Journal.  As a member of “The Experts,” a group of industry professionals convened by the Journal to comment on investing questions, I was asked what makes a good analyst.

Since a fair number of essays on this site deal with that question in one way or another, I had plenty of material from which to choose.  My answer,Wall Street Journal | This is a compilation of some of the responses to the question, including mine. in a nutshell:  Don’t go looking for the best analysts in rankings of those with the best statistical performance over some limited period of time.

Despite the fact that performance derbies in every corner of investment endeavor inevitably lead to performance chasing and bad decisions by individual, institutional, and professional investors alike, decision makers persist in thinking that numbers and rankings tell us something that they usually don’t.

That said, it was worth noting that Morningstar analysts showed well in this year’s WSJ derby.  Most readers probably don’t even think of Morningstar as being “on the Street,” but it has been providing equity research to its clients for more than a decade.  (I conducted due diligence on the firm’s research product over a multi-year period as a part of the Global Research Analyst Settlement.the research puzzle | This PDF provides links to a series of postings that I did on the various aspects of the independent research portion of the settlement.)

An articleWall Street Journal | More detailed explanations of the firm’s equity research approach are available from Morningstar. accompanying the survey covers the basics of the Morningstar methodology, which is much different than that found at almost all of the other firms that have analysts represented.  Every approach has its weaknesses, including Morningstar’s, but the firm tries to negate the effects of one of the most prevalent and damaging research flaws:  Analysts tend to lose sight of the value of a business in the fog created by current market pricing.

To avoid that, by design Morningstar’s approach leads to a less attractive rating as a stock price moves higher and a more attractive rating as it moves lower (assuming the estimate of the fair value of the firm remains the same).  It is a value strategy, not a momentum one, which may or may not be for you, but it is clearly defined as to what it tries to do and what it doesn’t try to do.

Discipline is key, whether you are a value player or a momentum player, and Morningstar has tried to provide a structure that manifests its philosophy.  A well-executed momentum approach would do the same.  The classic problem for sell-side analysts is that they get caught without a workable framework to guide them through the ups and downs of markets.

They (and the philosophies of the firms they represent) tend to be neither value nor momentum in a disciplined way — and they can be very susceptible to a risk inherent in the growth investing philosophy.  Namely, at times when price momentum in a stock has waned and value cannot be found, the disciples of those approaches (each which has support in the academic literature) don’t play.  Growth investors and Street analysts often do.  The tendency for each group is to wait too long for their faith in a story to play out.

Don’t be charmed by rankings of analysts.  Unless you have years of information and measure analyst output in several different ways, you’ll likely come to the wrong conclusions.  Spend your time instead trying to understand how analysts and firms say they will make their decisions, monitor them to see whether they adhere to that philosophy, and decide whether their approach fits how you think about the world and want to invest.

That is how you’ll find the best analysts for what you are trying to do.