- The chart below takes all the stocks in the S&P 500 and breaks them into five groups
- The first group on the left are the stocks analysts loathe (the worst-rated stocks)
- The last group on the right are the stocks most loved by analysts
- Stocks analysts dislike trade at a 34% discount to the market
- Stocks that are analysts’ darlings trade at a 17% premium to the market
Fundamental Analysts are Herding:
In the euphoric mania underway today, this does not surprise us. Consensus thinking among Wall Street analysts is the rule, not the exception. Unfortunately, it is also crippling for investor returns.
We believe stocks with the highest levels of consensus “buy” ratings, the “Darlings,” may be benefitting from self-reinforcing price action as high average returns in these stocks force analysts to shift to buy ratings. Contrarily, we believe that stocks that have the least support from analysts, “Dislikes,” are likely companies that have failed to achieve the spectacular performance in some of the top stocks beloved by speculators today.
In the rest of this post, we will provide evidence that the consensus “Dislikes” stocks appear to offer investors a great deal more value than the stocks analysts love (the Darlings). We believe this foots with common sense: if everyone agrees that something is bad or good, it is likely already in the price!
In this case, we find the fundamentals so compelling that we will be writing a great deal more about this in the near future.
Stock Market Analysts Have a Tough Job
John Maynard Keynes asserted that “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Having worked as traders, analysts, and portfolio managers for decades, the KCR staff understands this all too well. As certain stock prices move relentlessly higher, we believe fundamental analysis often becomes “technical analysis.”
Bottom-up approaches that work with financial statements and deep dives on balance sheets give way to stock ratings and price targets that are often glorified trend following. We do not say this to criticize the analysts charged with predicting price movements – far from it.
The pressures of remaining employed often undermine the traditional metrics and tools that have proven their mettle over centuries.
The table below shows the fundamental traits of the stocks in the first (Dislikes) and fifth (Darlings) bars above. Compare the two groups. What do you see? Here is what KCR sees going from left to right:
- Consensus: only 24% of analysts have these stocks buy-rated
- Returns: they have gone up 43% over the last 3-years (~14% per year)
- Cheap: they trade at only 2x sales and 15x forward earning
- Profitable: high ROEs, a stunning 4.4% yield
- Risk: These stocks have muted risk characteristics (beta of 0.86)
- Consensus: 85% of analysts agree – these stocks are buys – almost no dissent!
- Returns: they have exploded 113% over the last 3-years (~30% per year)
- Expensive: Priced at a 100% premium to the Dislikes (4x P/S vs. 2x P/S) & (28x PE vs.15x P/E)
- Profitable: these companies are profitable but have less than half the yield (1.7% vs. 4.4%)
- Risk: these stocks have a beta of “1” – in line with the market – but look at the 3-year growth rates for sales – a stunning 61%
We believe that the top analysts today are those willing to chase firms with high rates of revenue growth. As we addressed in our paper explaining the immense risks to even the highest quality growth stocks, growth rates this high are not sustainable for large cap companies like these. As a result, firms that are ramping up sales aggressively have become the DARLINGS of Wall Street.
Our research team believes that this fails the basics of common sense. How long can companies grow revenues at these outlandish rates? Considering the 100% premium in valuation, are these high rates of growth not already priced in? To what degree are the bullish analysts just chasing performance and trying to keep their jobs? What happens when these companies disappoint?
Analysis is a method of attempting to understand current and future share prices with a robust toolset. These tools can include a vast array of qualitative methods like meeting with management, visiting production facilities and trying products. But regardless of those processes, valuation is a critical component of any responsible analyst’s tool kit.
Typically, analysts attempt to use DCFs, private company transaction values, and peer comparisons to cross-check the conclusions. Yet every one of these valuation methods are easily manipulated to achieve the outcomes an analyst “needs.”
In our piece about how analysts choose their peers when setting price targets we showed the data proving that as prices and valuations move higher, analysts actively pick ever more highly valued peers to help justify the higher valuations! We were not then, nor are we now, pointing the finger at anyone. In fact, in that piece, we led out with a tacit admission that everyone on our team had engaged in the exact same behavior!
We have documented the relentless rise of some of the most speculative stocks in history. Our pieces, contrasting high-priced Tech stocks and Staples, exorbitant valuations, the confluence of record debt and high prices, and the explosion of frenetic day-trading have all made the precarious state of markets today obvious.
We have watched in dismay as the market prices of stocks like Twilio rise ever-higher despite minimal revenues and steep losses and do so with the full complicity of sell-side analysts. If you want a stark and shocking example of how the analyst community’s herding is impacting stock prices today, we strongly suggest you check out our updated post on Staples stocks. In that piece of free content, we contrast the valuation of that tech stock with the most proven money-makers out there: consumer staples.
It has been and continues to be our emphatic belief that the herding by analysts and investors into neat stocks today is no different than 1929, 1969, or 2000. As documented by our extensive collection of White Papers and Quick Takes, the good news is that this has many of the highest quality stocks trading at discounts to the market.
For a list of stocks that analysts LOATHE and we LOVE due to their high profits and reasonable prices please login or subscribe to see directly below.