How Bad Are Equity Analysts at Finding Good Stocks?

Here at Market Inference, we routinely take into analyst ratings and price targets when we review stocks. Our articles always emphasize the fact that these analyst opinions should be taken with a grain of salt. So if they’re not reliable, why do we even consider them in the first place? We view analyst opinions as a proxy for determining general market sentiment about a stock, and understanding the trend behind its price movements.

In this limited role, analyst ratings can help identify stocks that will perform well -- in the short term at least -- because they are essentially being promoted by the institutions that run the equity markets. The challenge lies in determining when it’s time to jump off the bandwagon and take profits. It’s a risky game, so we prefer the tried and true long term value and growth approach to investing.

Today we’ll consider two examples of the misleading nature of analyst ratings: Enron and Peloton (PTON). Both stocks demonstrated extremely strong performance followed by precipitous falls. Both stocks received consistently high ratings from analysts before, during, and after the periods of upwards performance. Both stocks showed that their analyst recommendations were essentially useless if taken at face value.

Enron is the more egregious example, since the fraudulent company presented itself as a blackbox from an accounting perspective, and simply expected analysts and investors to trust their phenomenal growth. Most analysts did just that, and a tragic number of investors followed their lead. Goldman Sachs analyst David Fleischer gave the company a buy rating despite telling the Wall Street journal about the company’s “lack of disclosure and transparency.”

With the company dropping more than 50% in the previous week, by the time the Wall Street Journal published these concerns on October 26, 2001, 15 out of 17 analysts who followed the stock rated it at either “buy” or “strong buy”. Credit Suisse analyst Curt Laudner is reported telling the WSJ: "I know I'm wrong on the stock.” But he doubled down on his buy rating anyways. By December of that year, Enron stock would be all but worthless as the company filed for bankruptcy.

In February 2002, during a Senate committee hearing into the analyst community’s blind and nearly unanimous endorsement of Enron’s shares, accounting professor and equity analyst Howard Schilit testified:

Everybody is saying they [Enron] hid from us, they lied to us, they committed a fraud. Did you read the public filings that were published at the SEC? I spent an hour of my time last night going through every quarterly filing proxy, no more than an hour, and I have three pages of warnings, words like "non-cash sales," words like "$1 billion of related-party revenue."

In other words, to someone with a background in accounting, the speculative and vague nature of Enron’s filings was clear enough to alert analysts to the potential manipulation of the company’s finances. But none of the analysts rating the stock even blinked.

Turning now to the more recent example of Peloton, we need to clarify that there is no evidence of fraud or obfuscation here. But we still find the comparison with Enron relevant because of the near unanimous recommendations from the analyst community, coupled with a near complete collapse in market value.

The home exercise equipment company went public in September 2019, and all 14 of the stock’s underwriters-- many of them working for the company’s equity underwriters--recommended the stock as a buy. At the time, Peloton was not a profitable company and its stock was trading in the low twenties.

By September 2020, the stock had quadrupled to over $80.00 per share, with JP Morgan and Bank of America setting target prices of $105 and $150 per share respectively. The company’s cash flows were positive, and despite widening gross margins, the company’s operating margins were still negative -- despite record sales. JP Morgan Analyst Doug Anmouth stated that he believed “there is significant upside potential to consensus estimates both near and long term.” (emphasis added).

Bank of America was right on the money: the stock traded above $150 per share for most of December 2020 and January 2021, before beginning a long and painful slide to its present price of $6.93 -- 70% below its IPO value of $25 per share. Analysts kept rating the stock at buy as it fell back to earth while incrementally adjusting their target price downwards (now the average target price is $17 per share).

The lesson here is that investors should either ignore analyst recommendations completely, or consider them in the appropriate context alongside the stock’s fundamental values. If the best equity analysts in the world couldn’t tell that Enron was smoke and mirrors, how can they tell if Peloton will reverse its downwards trend?

In case you are wondering whether PTON might now prove itself to be a solid investment, here are some facts you should consider from its last four annual reports:

Discouraging free cash flow trend
  • 2022 free cash flow : -$2,373,300,000
  • 2021 free cash flow: -$570,100,000
  • 2020 free cash flow: $219,900,000.0
  • 2019 free cash flow: -$191,600,000.0
  • Mean free cash flow growth: -153.6%
  • Coefficient of variability, where a high percentage indicates high variability: 156.8 %
Strong but declining gross margins trend
  • 2022 gross margins: 19.5 %
  • 2021 gross margins: 36.2 %
  • 2020 gross margins: 45.9 %
  • 2019 gross margins: 41.2 %
  • Gross margins mean growth: -19.3 %
  • Gross margins coefficient of variability: 32.4 %
Operating margins indicating an unprofitable business model
  • 2022 operating margins: -78.4 %
  • 2021 operating margins: -4.9 %
  • 2020 operating margins: -3.7 %
  • 2019 operating margins: - 27.1 %
  • Operating margins mean growth: -480 %
  • Operating margins coefficient of variability: 129.6 %

We hope the numbers above will encourage you to research the fundamentals of any company you are interested in as an investment! For more free fundamental stock analysis, subscribe to our newsletter today!

The above analysis is intended for educational purposes only and was performed on the basis of publicly available data. It is not to be construed as a recommendation to buy or sell any security. Any buy, sell, or other recommendations mentioned in the article are direct quotations of consensus recommendations from the analysts covering the stock, and do not represent the opinions of Market Inference or its writers. Past performance, accounting data, and inferences about market position and corporate valuation are not reliable indicators of future price movements. Market Inference does not provide financial advice. Investors should conduct their own review and analysis of any company of interest before making an investment decision.