If you live and die by the recommendations of Bay Street stock analysts, two things are likely to happen. You will almost never sell anything. And you will probably underperform the market.
It should not come as much of a surprise that equity research is skewed toward favourable stock ratings.
But data show that in the sell-side analyst community, bears are a species verging on extinction. Of all of the thousands of individual equity ratings on all of the stocks listed on Canadian exchanges, just 3.9 per cent are "sell" recommendations. And there is not a single stock in the S&P/TSX composite index with a median "sell" rating right now.
How does all that bullishness hold up against market performance? Over the past 10 years, a rotating portfolio of the best-rated Canadian stocks failed to beat the S&P/TSX composite index. That suggests that even the top analyst stock picks by consensus perform no better over the long term than the average stock in the index.
That does not mean that equity research is without merit or value. The lowest-rated stocks in Canada, for example, seem to generate poor long-term results.
As a result, investors might be better off listening to the skeptical few over the chorus of positivity that makes up the overwhelming majority of equity research.
"If an analyst has the guts to put out a 'sell,' it's worth paying attention to, much more so than every other stock that has a 'buy,'" said Norman Levine, the managing director with Portfolio Management Corp.
The role of the sell-side analyst has always been fraught with potential conflicts of interest.
They are expected to build relationships with the companies they cover, as well as the money managers who are clients of the brokerage. Those investor clients are an analyst's primary audience, but their reports are often distributed to financial media, where they reach the retail investing community.
Additionally, the companies under analysis may also be potential clients of the firm's investment banking division, making for an ethical minefield to navigate in trying to produce unbiased research.
By the late-1990s, stock analysis largely became a vehicle to generate underwriting revenues, and the equity-research business was blamed for supplying some of the air that inflated the dot-com bubble.
In 1999, for example, Merrill Lynch analysts had 940 "buy" ratings on stocks and "sell" recommendations on just seven.
The big brokerages in the United States and Canada alike, duly chastened for their role in the bubble, have nonetheless remained bullish.
There are currently more than 800 Canadian stocks with at least one analyst following them. Of all the individual stock recommendations – more than 5,500 of them – just 216, or 3.9 per cent, are "sell" recommendations. "Buy" recommendations account for almost two-thirds, while "holds" make up the rest.
That skew is not surprising, said Bryan Pilsworth, president and portfolio manager at Toronto-based Foyston, Gordon & Payne. "Life is easier with a 'buy' recommendation. If you've got a 'sell' recommendation, you risk being cut off from communications with that company."
It's not unheard of for companies to restrict access to management for analysts issuing negative research.
Retail investors who closely follow analyst actions may not fully grasp the pressure the sell-side community is under to frame a company's prospects in a positive light, Mr. Levine said. "They're looking for a quick way to identify what to buy and what to buy it at."
But it's not clear that the top sell-side stock picks make for better-than-average investments. A portoflio backtest using Bloomberg data shows a bucket of stocks garnering the highest analyst ratings – that is a score of 4.5 or higher on a five-point scale, on which 5 represents a "strong buy" – returned an average of 4.5 per cent each year over the past 10 years. The S&P/TSX composite index, meanwhile, posted a total return over that same time of 4.6 per cent annually.
"There are analysts that understand the minutiae of a company really well, and they understand the dynamics of the industry. But they may not necessarily be great stock pickers," Mr. Pilsworth said.
On the other hand, a hypothetical portfolio including the stocks with the lowest rating, that is those with a consensus score of less than 3 on Bloomberg, which equates to a "hold," performed much worse than the index over the past decade.
Although there are only currently six such stocks in the main Canadian index, an annually rebalanced basket of stocks viewed negatively by the consensus would have declined by an average of 2.8 per cent a year. That suggests the sell-side consensus knows what to avoid.
To get value out of equity research, Mr. Pilsworth suggests paying more attention to the content of the analysis than the recommendation or target price. And it helps to identify the best analyst covering any given company and follow him or her closely. Those individuals tend to know their stuff, he said.
"Sell-side analysts can get a bad rap. But they do absolutely provide value."
Tim Shufelt