The Best Way to Read Wall Street Research

The greatest job I've ever had... Where stock-picking prowess falls in the Wall Street hierarchy... A valuable piece of advice from my first director of research... Why 'buy' ratings can be a good contrarian indicator... The best way to read Wall Street research... Join us for the first-ever Cannabis Investing Event...

I (Thomas Carroll) spent 17 years on Wall Street before I called it quits...

But what a job it was!

When the first company I worked for – Legg Mason – hired me, I had almost no idea what a "sell-side analyst" was. After all, I grew up in a health care family and had worked exclusively in that industry since graduating from the Johns Hopkins Bloomberg School of Public Health.

At Legg Mason, my job was to cover publicly traded health care companies. Ideally, my work would encourage the firm's clients – professional money managers and so-called "institutional investors" – to buy those stocks (or related assets) from my firm. My new boss was betting that my knowledge of the industry would translate into better stock analysis and investment advice.

It was the greatest job ever...

I got to blend two big interests – health care and the stock market. I got to meet with the senior management for some of the best companies in health care and travel the world with them. I became personal friends with some of the greatest investors in the world. I got to go on TV and have friends tell me how good I was.

I made an incredibly good living... far greater than this public-school kid ever imagined.

But over that time, I learned some troubling things about Wall Street analysts. These things aren't apparent to the casual observer of the financial news.

The mainstream financial media cite the research notes and earnings estimates of analysts like these as if they were handed down from some higher authority.

If you read through the research produced by a sell-side analyst... please, please, please remember that things aren't always as they seem. Before you stake your investment dollars on these opinions, keep in mind that the accuracy of these projections falls far down the list of priorities.

In fact, that's probably the biggest misperception individuals have about the folks who go on TV to talk about stocks...

No one really cares if your stock picks go up...

Now, don't get me wrong... Having a stock do what you predict is always a good thing. It certainly helps your reputation. Institutional clients are always looking for moneymaking ideas – whether it's for their clients or in their own personal accounts.

But picking stocks and making money for our clients was not a primary focus. Being a successful analyst relied on a different skill that has nothing to do with finance and markets... All you had to do was please all the people all the time.

Instead, analysts like me were rewarded for...

1. Becoming an indispensable resource for institutional investors,
2. Accumulating buy-side "votes" annually, and
3. Aligning with investment-banking efforts.

Making good stock calls came in fourth behind all those priorities.

The first director of research I worked for (and also the best one) taught me a critical lesson...

He told me to become an expert in something related to the sector that you cover. That way, someone in the investment world will always seek your advice on the topic at hand.

As an analyst, having some special knowledge about the stocks you follow differentiates you from other analysts. You might have personal relationships with policymakers or academics in your sector that inform your opinions.

That proved to be a great piece of advice...

It helped through times when health care stocks were out of favor. Investors knew they could call me to learn something, regardless of whether they owned the stock or not.

Prior to becoming an analyst, I developed a deep understanding of government health care programs like Medicare and Medicaid. When it became apparent in late 2008 that lawmakers were going to create a new law called the Affordable Care Act ("Obamacare"), investors became skeptical of health care stocks. Many of them underperformed.

A big new law would surely create winners and losers. Government regulations aren't usually good for stocks. But in this case, I knew stocks that focused on government programs were poised to do great. New government money would soon flow into the system.

Investors who knew I had this experience called right away. Others who read our research also recognized that we had knowledge that others didn't. We were essentially teaching these investors. When the time came to buy the stocks, they were prepared to defend these decisions to their bosses.

Of course, many analysts figure out that making themselves "indispensable" can involve things that have nothing to do with knowing finance or markets...

Being a good golfer whom investors want to play with often qualifies.

Those 'indispensable' services also help with the second priority – the endless chase for 'votes'...

The critical clients – the big firms that manage retirement programs, pension plans, and "nest eggs" – have systems of tracking analysts.

The currency they use is collectively known as "votes." The more votes you get as an analyst directly relates to the commission dollars your firm will receive in a year (and your bonus).

If you provide good information to clients that help their portfolios make money, they will continue to seek your opinion. As they do that, they will also trade stocks through your firm's trading desk, and your firm will collect the commission on those trades.

All of this generates more votes.

One of the best ways to earn votes as an analyst is to host a meeting between your investor clients and the management of companies whose stocks you cover. A major part of equity analysis involves meeting and getting to know the management teams of the stocks you cover.

The more you can introduce your clients to those executives... the more indispensable you seem, and the more votes you get.

That seems like a straightforward relationship. But ask yourself... Do you like it when people say nice things about you? Does this make you act differently toward them?

For most people, the answer is obviously yes.

So the best way to get executives to make time for you is to let them see you saying nice things about their companies. Some management teams refuse to meet with an analyst (and his clients) if he doesn't rate the company's stock a "buy."

Many investment banks routinely have "buy" ratings on 55% or 60% of the stocks they cover. And as few as 2% merited a "sell." (The rest were in the "hold" no-man's-land.)

Even worse, most analysts tend to downgrade from a "buy" rating only after bad news has emerged. That's right. An analyst will put out a report after the company reports bad news and say the stock is no longer a "buy."

That is not helpful to anyone. If anything, "buy" ratings can be a good contrarian indicator.

Just look at Molina Healthcare (MOH)...

The analyst community was consistently skeptical of Molina.

Analysts tended to be more critical of the management team for this mid-sized Medicaid health insurance company. It wasn't a sought-after company to host meetings.

Enthusiasm for Molina hit its lowest in June 2017, when only 13% of analysts rated the stock a "buy."

But you could have bought the stock at that point for about $70 per share. And you could have sold it a year later at about $96 per share. That's a 37% gain in a year. By mid- September 2018, you could have sold it for about $145 per share. That's a 100%-plus return for buying a stock that most analysts told you not to buy.

On the other hand, 57% of analysts rated Molina a "buy" in August 2015. That was its highest level of support. If you bought it then, you would have paid about $75 per share... and watched it fall to $57 per share over the next year. That's a 24% loss in a year.

So whose interest is really being served by those buy-hold-sell ratings? Clearly, analyst support, or lack thereof, is often influenced by things other than what benefits the individual investor.

The other lucrative way to finance the research effort is raising money for companies...

That's also known as investment banking.

Taking a company public generates loads of capital for an investment bank. And once again... a big part of winning investment-banking business comes from offering favorable analysis.

That is what got the industry in trouble during the dot-com boom. Internet analysts wrote glowing reports on technology companies that were completely irrational in hindsight.

Recall the name Henry Blodget?

He was an Internet analyst who published shining reports to investors, even while he was trashing those same companies in private e-mails to colleagues. Blodget's e-mails became a centerpiece in then-Attorney General for New York Eliot Spitzer's attack on Wall Street for unscrupulous research behavior.

Most analysts aren't as shameless as Blodget...

But after 17 years on the job, I can tell you all sell-side analysts feel some pressure to help support the investment-banking efforts. This notion sits in the back of their minds as they publish research on investment-banking clients. And they know management is always watching.

So when you see an interesting initial public offering, check the ratings of the analysts who work for the investment bank that managed the process... They're almost always "buys."

So analysts twist themselves in all sorts of ways to please clients... but what hasn't factored into our discussion yet?

Actual investment returns.

Good analysts are out there...

Despite the pressures, many teams of analysts try to keep their focus on putting out quality research and stock recommendations.

Individual investors do have a source to find good analysts. Annually, reputable sources like the Wall Street Journal and StarMine Analytics attempt to weed through the giant "pile" of equity research. They look for consistent, honest research that results in good stock calls.

For the individual investor, we would recommend checking out these two annual surveys.

When I was at Legg Mason and Stifel Financial, my team and I were honored to be selected during many of these surveys over the years. And looking ahead, I'm excited to bring the expertise I've gained to Stansberry Research and its loyal subscribers.

But the point is, when looking at the reams of Wall Street equity research, the reports and ratings are not always what they seem.

As an individual investor, we would recommend a grain of salt (sometimes a mound of salt) when considering the content of investment bank-sponsored research. It's not all bad, and it's not all good.

But it seeks to please all the people all the time. And that hardly ever works out.

If you're researching a stock that has been rising and all the analysts have a "buy" rating, please double-check everything. If the stock keeps rising, those ratings can only go one way. That could impact the stock.

Conversely, if a stock has no analyst support but your research suggests it's a good business, that can work out to be a great buying opportunity.

Do your homework when something doesn't smell right. On Wall Street, things often stink.

New 52-week highs (as of 3/18/19): American Express (AXP), CBRE Group (CBRE), Ionis Pharmaceuticals (IONS), Ingersoll Rand (IR), KLA-Tencor (KLAC), Microsoft (MSFT), Nestlé (NSRGY), and T-Mobile (TMUS).

The feedback on Friday's Digest on the U.S. health care system is still rolling in. As always, send your comments and questions to feedback@stansberryresearch.com.

"Last year my wife went in for a Pelvic Exam to insure Cancer Coverage. Her Dr found an abnormality which could have been Bladder or Ovarian. Local Hospital and clinic of which the Dr was a member wanted $1100 for the Ultrasound plus reading charges for the Dr. I researched and found a clinic that did the complete Ultra Sound and reading for $388.00. The result was a Rogue Ovary which was removed by the OBGYN Clinic which was impressed by the quality of the Ultra Sound. Shop around" – Paid-up subscriber Jim S.

"I read with interest the case of Paid-up subscriber David T. in the last Digest where he ended up in an observation unit. That will never happen to me. I have advice from 2 doctors and one insurance professional to NEVER accept admittance to anything that is not a full hospital admittance.

"Why? Because most insurance will NOT cover the costs of 'observation'. I will always insist on admittance to the hospital or discharge. Observation is not less expensive for the patient in most cases..." – Paid-up subscriber M.C.

"I always tell patients not to go to an ER unless they are dying or think they are dying. It is expensive and more often than not, the correct diagnosis is not made.

"Also suggest not paying a bill for a doc if you never saw one. PAs are supposed to be SUPERVISED. They are 'physician assistants' not primary providers and having testified in many legal cases, I can tell you their knowledge is very limited and borderline dangerous. They are best to check back on patients AFTER a real doc has made the diagnosis and suggested treatment. They can also do some tasks (like place a splint etc.) to free the doc to see new patients. The problem is the docs sit in the break room and mid-levels (NP, PA, RN) do all the work. It's unethical and dangerous. DEMAND excellence and you may be surprised.

"I don't use mid-levels any longer because of the inferior care and knowledge. Med school/residency/fellowship are long for a reason (10yrs after college) and not like the 2 yrs mid-levels get spending a month or so in any one specialty. Congress needs to demand insurance companies be changed to mutual insurance companies and things would improve. Savings to policyholders not shareholders. Current system is horrendous." – Paid-up subscriber David B.

"I am from small-town Iowa and my experience with our local hospital and health care facility was great. I went to the doctor and then straight to the hospital because I was severely anemic and needed care right now. We have a County Hospital, two clinics and a pharmacy that are all under one ownership, and it works out wonderful. Anyway, after I was admitted, I was seen right away and meds etc. were started. I also had blood pressure problems and that was addressed. The staff was excellent – doctors, nurses, etc. and even down to the cleaning people. I was then transferred to a Health Care facility and my care was also excellent there. I am on Medicare and my bill at the hospital including ER was $11,000.00 but Medicare only paid a small part of that. I feel fortunate and I wanted you to know the other side of medical care." – Paid-up subscriber Isabelle F.

Good investing,

Thomas Carroll
Baltimore, Maryland
March 19, 2019

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