The Good, Bad, & Ugly of Analyst Upgrades

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Back in January, I wrote an article called “Analysts Play Follow-the-Leader this Earnings Season” that showcased how analysts follow the calls of other analysts and are influenced by stock price moreso than fundamentals. Today, I am looking at another aspect of analyst calls – that not all calls are created equally. Some are good, others are bad, and some are just plain ugly!

The Makings of a Good Call

The resources, contacts, and data that analysts have at their disposal is mind-boggling. Their job is to assess a company and its upside, using tools and performing research that aid in the investment decisions of retail and institutional investors.

While just about all analyst calls will create movement, not all of them are good. A good call offers something new. It provides insight from an analyst’s findings or a thorough and detailed explanation for the call.

On Tuesday, Piper Jaffray raised its price target from $23 to $28 on Select Comfort (NASDAQ: SCSS) – and it was a good call. Piper Jaffray specifically cites its reason as being store checks that indicate better-than-expected sales volume. This is the type of research that an analyst should perform. They should be calling, visiting, and assessing individual stores and the inner workings of a company to determine upside – and that’s exactly what Piper Jaffray did with Select Comfort.

As a result of the good call, Select Comfort saw its stock rise more than 8% on Tuesday. The stock surely benefited from the increased volume comments, but also Jaffray’s assessment of the company’s new DualTemp product – saying it should provide a 2%-4% comp boost. Overall, Jaffray made a great call, providing fundamental changing information that was unknown to the general public – which is exactly what you seek in a “good” upgrade.

Being Timely Is Important in Being Good

Texas Instruments (NASDAQ: TXN) boosted its quarterly dividend by 33% and added an additional $5 billion to its share repurchase program back in February. As a result of this move, several analysts upgraded the stock.

Following the dividend/buyback news, analysts had every right to upgrade the stock – as the news significantly changed the outlook for the stock. However, when an analyst upgrades a stock three months after the news – and cites the three-month old catalyst as the reason for the upgrade – it is no longer timely information to offer the investment community.

In addition, Texas Instrument is trading with at 22.5 times earnings, which is far greater than the 15 times earnings seen by the technology sector. Thus, the news has been priced into the stock, and Drexel Hamilton’s upgrade to “Buy” is pretty late to the party.

Now, what makes this upgrade bad is that there were no other notes issued with the call. The firm had already issued a “Hold” rating with its previous report. Thus, the company must not believe that anything has changed from its previous report with the exception of the buybacks/dividend.

With Texas Instrument being a stock already covered by Drexel Hamilton, the firm should have responded to the dividend/buyback news before the end of May. Then, a revised price target based on the news would have been good – but its lack of being timely makes it bad!

The Ugly Is Plain Lazy

For every buyer there is a seller, meaning that I am not going to agree with every call made by an analyst. Therefore, a difference of opinion does not bother me nor does it dictate whether I think a call is good or bad. However, a lack of reason does indicate a bad call – and when that reasonless call creates significant gains – it is an ugly call!

HealthStream (NASDAQ: HSTM) is currently trading with gains of 4% after Avondale Partners raised its price target to $31 from $25. The problem is that Avondale Partners did not issue any public notes with the upgrade (bad upgrade). Also, the stock rallied 4% without any new catalyst being mentioned (making it ugly).

When a stock overreacts to an upgrade or downgrade that provides no public insight or opinion, it can create a trap for retail investors. A lot of retail investors are attracted to stocks that have wide coverage – but if that coverage lacks substance then it could be a stock that’s inflated due to the analyst calls alone. This means that it wasn’t channel checks, industry quizzes, or exceptional due diligence that created the rally – but rather the call alone.

Conclusion

I have often discussed that investors can find value from analyst upgrades/downgrades. When a stock rises because of a good call it’s due to something that was unknown in the past. These calls can present an opportunity for the investor – and should aid in your research of a company.

Personally, I don’t like Select Comfort. I think the business is too fragile and I have witnessed as both it and competitor Tempur-Pedic have lost value in excess of 40% during a single day. With that said, investors must still acknowledge that Piper Jaffray made a well-researched call.

Regardless of whether or not that call leads to future fundamental gains is unknown – but the key is to learn how to identify the difference between calls, and know that only those that are good should be used as guidance. 

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