Why sell-side analysts are wrong

By Felix Salmon
June 21, 2010
Aaron Pressman has a good report on the sell-side failure to perceive the risks surrounding BP in the wake of the Deepwater Horizon catastrophe. Why was Wall Street so very bullish on the stock even as it was being pummeled in the markets?

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Aaron Pressman has a good report on the sell-side failure to perceive the risks surrounding BP in the wake of the Deepwater Horizon catastrophe. Why was Wall Street so very bullish on the stock even as it was being pummeled in the markets?

Pressman points to a number of factors, including banks’ desire for a healthy relationship with BP, and analysts’ tendency to cluster together for comfort. Joshua Brown reckons it’s deeper than that, and that sell-side analysts tend to see everything in terms of value and discounted cash flow, which are not particularly useful tools when companies get hit by unexpected tail risks.

And more generally, as Lynn Thomasson shows, sell-side ratings are a pretty good contrary indicator:

Wall Street’s lowest-rated stocks have turned into this year’s best performers…

Huntington Bancshares Inc., the regional lender in Columbus, Ohio, had twice as many “sell” ratings as “buys” in December and jumped 66 percent this year for the fourth-largest advance in the Standard & Poor’s 500 Index. Eastman Kodak Co. and Sunoco Inc. have gained more than 20 percent after more than 30 percent of the analysts covering them at the start of the year recommended getting rid of the shares…

Coca-Cola Co., the world’s largest soda maker, had 14 “buys” and 1 “sell” rating in December and has lost 8.2 percent this year…

Pfizer Inc., the world’s largest pharmaceutical company, is down 16 percent this year even after 81 percent of analysts covering the New York-based firm said investors should buy shares.

The one part of all of this I disagree with is in Pressman’s piece:

Wrong-way Wall Street calls are more than just an academic problem. They cost real people real money.

This was the theory behind Eliot Spitzer’s war on sell-side analysts; it was dubious then, and it’s even more dubious now. Investors — even retail investors — aren’t sheep who simply do what they’re told by sell-side analysts. Institutional investors, in particular, use sell-side analysts as a source of ideas, and even more as a source of access to the company. Big investors are a little bit like bloggers, actually, but instead of linking to articles and then saying what they think, they give out soft-dollar commissions and put on their own trades. Which, like blog entries, can either agree or disagree with the original idea.

But Brown’s point is important as well. Sell-side analysts live in mediocristan, and are prone to being blindsided by the unexpected; they almost never, for instance, recommend negative-carry trades. Investors, if they’re any good, know this. No one ever made money by blindly following sell-side advice, and so we should hardly be surprised that people whose position coincided with the sell-side consensus ended up losing a lot.

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Comments
9 comments so far

BP is full of problems, but they are priced for doomsday.

BP has nearly the same revenue as ExxonMobil, about the same earnings, and about the same cash flow. Meanwhile, BP has a market cap under $100 billion, while ExxonMobil has a market cap of about $300 billion.

So the market is pricing in a $200 billion or 2/3 handicap to BP. Isn’t that a little bit much?

Posted by DanHess | Report as abusive

“Sell-side analysts live in mediocristan, and are prone to being blindsided by the unexpected; they almost never, for instance, recommend negative-carry trades. Investors, if they’re any good, know this. No one ever made money by blindly following sell-side advice, and so we should hardly be surprised that people whose position coincided with the sell-side consensus ended up losing a lot.”

Agreed.

Posted by ottorock | Report as abusive

Dan, you’re doing the same sort of analysis that Felix ascribes to the sell-side analysts – it can’t possibly cost $200 billion to clean this up. The problem with that thinking is that the bottom is still unknown, and will be unknown for a long time. What happens if the relief wells fail? What happens if health or environmental risks come from an unexpected direction? What happens if Tony Hayward organizes his next regatta in Mobile? It’s not clean-up costs the market is pricing, but unknowns. I can’t say you’re wrong, but I’m not willing to bet money that you’re right.

Posted by Curmudgeon | Report as abusive

“Why was Wall Street so very bullish on the stock even as it was being pummeled in the markets?”

Felix once again can’t let go of his beliefs in the EMH.

I like Curmudgeons analysis. I also like Dan’s analysis, though I’d note to Dan that XOM is largely thought to be better at long-term management than BP, and that current events aren’t the entirety of the risk premium you’re looking at. Even at current prices, this is a risky stock, and while I could imagine someone responsibly buying it (for reasons Dan gives), I certainly don’t think anyone should be loading up on it. If you like to keep a small portion of your portfolio in higher-risk plays, BP, the old widows-and-orphans dividend stock, has moved to that chunk of your portfolio. Keep the rent money somewhere else.

Posted by dWj | Report as abusive

@Curmudgeon, so are you saying that $200 billion is a reasonable amount for BP to be spending on this?

BP’s cost in this thing so far has been about $2 billion. That includes “the cost of the spill response, containment, relief well drilling, grants to the Gulf states, claims paid, and federal costs”.
http://www.businessweek.com/news/2010-06 -21/bp-falls-as-cost-of-oil-spill-reache s-2-billion-update1-.html

So you really think BP might be only about 1% of the way through the costs of this? Okey doke…

Posted by DanHess | Report as abusive

Dan, you’re still thinking what it’s going to cost to clean up. I’m offering the hypothesis that the cost to BP’s market cap may be greater than just the cost of cleaning up the spill. Some of that is known at this time, and some is unknown (such as long-term health problems that may be traced back to the spill, or higher borrowing costs because of lower credit ratings). Some may be intangible (such as brand power, or quality of management) but reflected in a depressed value for a long time.

Posted by Curmudgeon | Report as abusive

Some points:

(1)
Unlike with say Goldman Sachs, BP’s product is 0% reputational. Theirs is an essential commodity and 100% of their inventory will always be sold. The Air Force bought BP oil to fly Obama down so he could yell at BP. How is that for a captive market?

(2)
Managements come and go. There is a mean-reverting aspect to it. Do you think the next management at BP will be better or worse than current management?

(3)
After years of sorting things out in the courts, Exxon’s final tab including all damages in re the Valdez was in the low single digit billions. This is certainly bigger, but not boundless. The relief wells are considered nearly certain to work eventually and in any case all gushers peter out gradually.

(4)
BP so far has rolled over and paid up nicely, for PR reasons and because they are in a strong financial position. But if their backs were against a wall, they have a lot of options. They have chosed to be complaint rather than combative. Things they haven’t done but could include suing their drilling partners for their share, fighting for enforcement of the controlling law that limits their liability and fighting individual claims in court. They could also detach their US subsidary and bring the fight to Britain, where opinions are 180 degrees different what they are here.

Posted by DanHess | Report as abusive

If you think this disaster is not going to wipe out BP bondholders, by all means buy their paper (full disclosure: I have been). But don’t kid yourself in equating the company with Exxon. Ask some people who’ve been around the industry for a few decades how people view the two. They’re.. different.

If you’re going to plunge in on the equity side, by all means, put your money where your analysis leads you. I would consider what the common is really worth under a bad-but-not-unthinkable Gulf scenario, though. In a mostly unrelated piece, Russell Napier wrote last year that “[e]quities are the fine sliver of hope between assets and liabilities.” If liabilities start balloon enough, they can extinguish it.

Posted by wcw | Report as abusive

In any worst-case scenario that wipes out BP shareholders, it may be foolhardy to think that bondholders would be spared. If things got that bad, the niceties of settled law would fare no better than they did in the GM and Chrysler bankruptcies.

There is considerable political risk here: in effect, there is no such thing as senior debt of BP. New equity in a post-bankruptcy BP would be handed to fishermen and other “stakeholders”, not to “greedy speculators” like yourself.

Posted by anon242 | Report as abusive
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