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Analysts Play Follow-the-Leader this Earnings Season

Brian is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I, like many, listened to and followed closely the Facebook (NASDAQ: FB) earnings report and call on Wednesday and believed the results to be very good. Almost immediately following the top and bottom line beat, and the release of its report, a number of analysts issued bullish notes as the stock ticked higher. However, as the stock then turned to the negative, we saw a shift in perception as analysts suddenly “changed their minds.” This is a common trend that we’ve seen this earnings season, and for the last decade, but what does it mean, why does it happen, and how should investors play it?

Understanding Analyst Behavior

I am a firm believer that investors should use the outlooks of analysts as part of their due diligence in an attempt to make an investment decision. In my book, I wrote about the psychological impact of analysts both on the investment community and on other firms. A “follow-the-leader” approach has always been popular among analysts, since the dot-com bubble burst, and over the last two years we have seen an increase in mindless calls that follow price in favor of individual analysis.

Last year I chose Sprint (NYSE: S) as my “value of the year.” I figured that with the iPhone and at $2.30 it was worth more than it was the previous year at $5 without the iPhone. Yet as the stock traded flat for five months and fundamentals continued to improve, hardly any analysts came to its defense. The outlook for Sprint remained negative and it wasn’t until it crossed $3.50 and begun to trade higher that those same analysts started to upgrade the stock. But wouldn’t it have made more sense to upgrade at $2.30 rather than $3.50 and $4.00? Of course it would have made more sense, but this is what happens inside the world of analysts making calls on stocks. They simply wait for someone to lead the charge and then the majority follows suit.

What Does it Mean & Why Does it Happen?

So what does it mean that analysts play follow-the-leader and wait for one analyst to make the call before following the pack? And why is it that these individuals prefer this course of coverage over independent thinking? The truth is that it’s a competitive world, and there are numerous firms of research that issue calls. These calls are crucial to the perception of several investment banks and or firms. Therefore, the outlook for a stock by a firm is often connected to public perception of that firm. If an analyst makes a bullish call against the pack and it doesn’t pan out, then it’s possible that other firms could use that call against them or that it would look bad to current clients.

An analyst follows-the-leader for the same reason that large investment firms invest in index funds -- to perform equal with everyone else. As hedge funds continue to underperform the market and their tracked benchmark, funds have chosen to invest in indexes to ensure that performance is equal to the performance of the market. This lowers the risk of clients leaving their firm; and the same can be said for analysts. These analysts work for the firm, and their calls are consistent with that of Wall Street, therefore allowing a balanced playing field. However, this practice hurts the retail investor, and sometimes the valuation of a company, which reacts so mightily to these calls.

How Can Investors Play the Calls?

The ultimate question is what does this practice mean and how can investors utilize this information? The answer is a psychological response, one that can only be explained by understanding how the market reacts to an analyst upgrade. We, as retail investors, take the advice of analysts and respond to their calls. Once an analyst initiates coverage with a “Buy’ or even an upgrade, it can create gains of anywhere between 3% and 10%. If you take a stock such as Sprint back in 2011, Facebook when it was below $20, or Apple today, these are all oversold stocks. Therefore, an upgrade can spark a rally. If the rally continues we then begin to see the “follow-the-leader” reaction.

We have seen follow-the-leader analysis on both the upside and downside. We saw analysts downgrade Facebook while it was falling but then upgrade the stock as it has risen. In fact, analysts have been a primary contributor to the gains of Facebook. Furthermore, we’ve seen it recently with Alcatel-Lucent, Nokia, and Research in Motion, but then as the stocks trend lower the outlooks change.

The bottom line: It only takes one analyst and slight gains to initiate this reaction. However, if a stock is trading lower or is at the bottom of its range, and is obviously undervalued, you won’t see these upgrades. As a result, I suggest waiting to buy stocks after that first upgrade following a series of downgrades. Of course the topic itself is very broad, which I explain here, but over the last year we have seen that this trend will produce large gains for investors who notice the trend and act.

Conclusion

The fact of the matter is that the “follow-the-leader” coverage will continue. The markets are too volatile, investment firms are too competitive, and no firm wants to take too large of risks. There is proof of this action scattered throughout the market. In the last day alone, Regions (NYSE: RF) was downgraded twice after being upgraded continuously for the last year due to increased fundamental strength. Now, the stock might fall lower as the domino effect begins.

The best example comes from Facebook, and BMO, as the firm downgraded the stock after issuing bullish notes following its earnings report. This is the same firm that had a “Sell” rating at $23 and then magically turned bullish with a “Buy” rating last month despite the stock being higher.  This doesn’t make sense but it occurs, as analysts either follow-the-leader or fall into the same mental traps that hurt retail investors. Either way, it can be damaging to invest against these calls while they are occurring but can be a blessing if you realize and purchase once the outlook begins to change.


BrianNichols has no position in any stocks mentioned. The Motley Fool recommends Facebook. The Motley Fool owns shares of Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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