The smart way to use stock market analysts
Forget about buy, sell and hold ratings. What really matters is how analysts change earnings estimates.
(MONEY Magazine) -- Securities analysts may pull down huge salaries and bonuses, but there's little evidence that their buy, sell and hold recommendations on big blue chips do any better than the S&P 500 index.
That doesn't mean you should ignore analysts in managing your own stock investments. Their opinions can help - just not in the way you might think.
Analysts have some success in spotting gems among small growth stocks and similar opportunities. But their recommendations on the biggest stocks slightly lag the market. One reason is that leading stocks are so well followed, it's hard to discover anything that isn't known.
Another problem is that ratings are often months out of date. Even if most analysts rate a stock as a strong buy, many of those recommendations may have been made when the price was lower. Besides, if a stock has long been highly rated, most investors likely to buy it will already have done so. So where will new buying come from to push prices higher?
Changes in ratings are a better signal, since an upgrade attracts fresh investors. But there's an even better bellwether: changes in earnings estimates. It doesn't matter what analysts think about management or corporate strategy. What counts is how they size up the bottom line.
"Rising estimates are not only signs that the next year will be better; they're also indicators that a company's long-term growth rate may be increasing," says Adam Cohen, director of quantitative research at Zacks Investment Research in Chicago. "And when one analyst raises estimates, others are likely to follow."
The effect of rising earnings estimates can be substantial. Last year the 10 percent of companies with the most positive earnings revisions outperformed the bottom 10 percent by almost 20 percentage points.
Reaching your own financial goals still depends on finding solid companies with a generous combination of earnings growth and dividends. But not all such stocks are good buys at any moment.
To find the ones that are, look for low P/Es and upward earnings revisions.
MONEY asked Zacks to analyze changes in earnings estimates from mid-April to mid-July for stocks in the Sivy 70.
Fourteen of the stocks in the Sivy 70 got the highest scores from Zacks, which means that all the analysts who revised earnings estimates raised them. Among this group, companies such as Colgate, Schlumberger and Walgreen look fully priced. Their strengths are widely recognized by investors.
But there are also a few bargains. These are typically companies with price/earnings ratios that are low to moderate because of some challenge the company faces. If that problem is on its way to resolution, the stock stands to reap big gains.
Here's a look at three such companies, each a leader in its industry.
FedEx posted a 25 percent gain in net income for the fiscal year that ended May 31. Three of the company's businesses - air express, ground shipment and freight - are thriving.
One reason: FedEx (Charts) has been very successful at passing increases in fuel costs along to its customers through surcharges. The challenge for the company is its 2004 acquisition, Kinko's, a copy and business-services chain that has been disappointing so far.
Systematic investment in Kinko's - including new outlets and revamped stores - should put the division on the track to higher profits.
Merrill Lynch enjoyed a 44 percent earnings rebound in the second quarter. But the share price is still down 14 percent since April, largely because a stagnant stock market generally depresses brokerage shares. Still, Merrill's three major businesses (brokerage, investment banking and asset management) are performing well.
Trading at a dirt-cheap P/E of 10.1 times estimated earnings for 2007, Merrill (Charts) should profit substantially in the next bull market, and the long-term outlook appears bright thanks to the increasing number of affluent people worldwide.
Omnicom is a giant advertising and public relations conglomerate, owning three of the 10 largest ad agencies and a host of related businesses. Moreover, Omnicom (Charts) is continuing to acquire smaller firms. In July it bought a majority interest in San Francisco ad agency EVB.
But soft advertising spending in many industries, and uncertainty about how the Internet and other new technology will change the ad game, are depressing the stock. Once the smoke clears, however, odds are that the world's leading agencies, Omnicom among them, will come out on top.