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| The Basics | Follow analysts to their sweet-spot stocks
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When more analysts start to 'discover' a stock, it often signals a trend -- and a good time to buy. Here are some tools that can help you pinpoint stocks in analysts' sweet spots.
By Harry Domash
Given the shenanigans Wall Street analysts pulled in the dot-com era, it's no surprise that many investors don't pay much attention to their buy or sell recommendations. In fact, according to some studies, you'd do better buying stocks that analysts advise selling than you would with their "strong buy" picks.
But that doesn't mean that you should ignore analysts' ratings and forecasts. Not entirely, anyway. There's plenty of moneymaking information there. I'll show you how to use it in a minute.
Two sides of the stock sale
Stock analysts come in two flavors: buy-side and sell-side.
Full-service brokers such as Merrill Lynch and Smith Barney employ legions of analysts to issue stock research reports. Originally, brokers derived most of their profits from commissions on stock sales. One purpose of the analysts' research reports was to encourage stock trading, hence the name 'sell-side analyst.'
Mutual funds and other institutional investors read sell-side reports, but many also hire their own analysts.
These buy-side analysts arrive at their own conclusions about a stock's outlook. The institution may decide to buy or sell based on its analysts' view rather than the published sell-side research.
For instance, the institution would sell a stock with a sell-side consensus earnings forecast of $1 per share if its research said the company would only earn 50 cents. Conversely, the institution would buy if its analyst were predicting $1.50. Buy-side analysts don't publicize their findings because they want their own money managers to gain an advantage over other investors.
So when we talk about published analyst buy/sell ratings and forecasts, we're referring only to sell-side analysts.
When a 'buy' is called a buy
Analysts typically publish ratings for each stock they cover. Other companies, such as Zack's Research, compile the individual analyst opinions into consensus ratings for each stock. Although analysts use varied terminology to express their opinions -- some "overweight" a stock when they like it and "underweight" it when they don't -- the compiling services categorize ratings as strong buys, buys, holds, sells and strong sells.
The consensus ratings are essentially the average of the analysts' ratings. For instance, say two analysts are covering a stock; one rates it a strong buy and the other a strong sell. The consensus rating would be hold, even though neither analyst issued a hold recommendation.
Analysts also typically publish earnings forecasts for the current quarter, next quarter, current fiscal year and the next fiscal year. The forecasts are usually made on an earnings-per-share basis.
Related news and commentary on MSN Money
The compiling services then average the individual analysts' earnings estimates to come up with a consensus forecast. For instance, say two analysts publish forecasts for this fiscal year, one at $1 per share and the other at $2. Using those figures, the consensus earnings forecast would be $1.50 per share.
Here's how you can use analysts' consensus ratings and forecasts to pick better stocks.
Analyst coverage creates demand
In the end, stock prices are all about supply and demand -- not for a company's products, but for its shares. A stock goes up on days when buyers want to buy more shares than sellers want to sell and down when sellers outnumber buyers. It's that simple!
The supply side of the equation is the number of available shares, or float, which is relatively constant. Demand, however, hinges on how many investors know about a particular stock. Analyst coverage is a key factor on that score.
Here's why: Major full-service brokerage houses employ hundreds, if not thousands, of stockbrokers. When an analyst issues a report, it goes to all of the firm's brokers. They, in turn, relay the recommendations to their clients. Thus, a single analyst's report might be read by thousands of potential buyers.
A company can do great things but, without sufficient analyst coverage, its stellar performance can go unrewarded in terms of share price because few know about its accomplishments.
The goal of many investors, including me, is to find an undiscovered stock just before everybody else gets on the bandwagon. In my view, the number of analysts following a stock is the best gauge of whether a stock is undiscovered or discovered.
The analyst-coverage sweet spot
Of course, there are variables such as the number of shares out and other publicity the company has received. But, in general, I've found that it usually takes at least five or six analysts covering a stock to generate enough interest to move the shares up substantially when something good happens.
Once you get more than seven or eight analysts, most players know the stock and more coverage is not necessarily better. The most widely followed stocks can have 20 or more analysts. For instance, the last time I checked, 29 analysts were following Oracle (ORCL, news, msgs) and 32 were issuing buy/sell ratings on Intel (INTC, news, msgs).
In terms of jumping on a stock just when it's being discovered, the ideal situation is when the number of analysts increases from, say, two or three a few months ago, to five or six today.
You can use MSN's Analyst Ratings report to see whether a stock fits that requirement. The report shows the number of analysts currently rating a stock in each of the five buy/sell categories. For example, it might list three strong buys, two buys and two hold ratings. Using those numbers, a total of seven analysts are currently following the stock.
The report also lists the same information for dates one, two and three months back. If only three analysts were following the stock three months ago, you've found a candidate in the sweet spot in terms of transitioning from undiscovered to discovered.
Your friend the trend
Earlier I described how compiling services come up with consensus earnings forecasts. While the current forecasts are significant, it's the changes in consensus forecasts that move share prices. Stocks move up when analysts raise their estimates and down when the consensus forecasts drop.
But here's the interesting part: Consensus forecasts have an uncanny knack for moving in trends. That is, once the consensus forecast moves, either up or down, it often continues in the same direction for weeks, if not months. That makes sense because once one analyst makes a significant change, other analysts fire up their spreadsheets to see if they've missed something. Many times they decide that they have and move their forecasts in the same direction.
A positive trend tells you that analysts are becoming increasingly optimistic about the company's prospects and the firm is likely to exceed even those recently increased forecasts when it reports quarterly results. Conversely, a negative trend signals a deteriorating situation.
The Consensus EPS Trend section of MSN's Earnings Estimates report shows you the current forecasts and the forecasts as they existed one, two and three months ago. Hence, discerning the trend requires only looking at the report.
I pay most attention to the current and next fiscal year trends because they tend to be more stable than the quarterly numbers.
Stocks with positive-trending forecasts are your best bets, but those that aren't trending are OK. Avoid stocks with negative-trending forecasts.
Surprise, surprise
An earnings surprise is the difference between consensus forecasts and the company's actual reported quarterly earnings. It's a positive surprise if the actual earnings exceed consensus forecasts and a negative surprise if the actual earnings fall short.
A negative surprise usually triggers a share-price drop. Worse, negative surprises often lead analysts to lower their forecasts, which pressures the share price even more.
Many investors believe that a company with a recent negative surprise is likely to fall short again when it reports its current quarter's results.
You can see a firm's earnings-surprise history going back five quarters on MSN's Earnings Estimates report. Avoid stocks with a history of recent negative surprises.
I don't recommend using the analysis procedures I've described by themselves to make a buy or sell decision. Nevertheless, they are worthwhile additions to your analysis toolkit.
At the time of publication, Harry Domash did not own or control positions in any of the stocks mentioned in this article.
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