Why analysts hate putting out sell ratings
Herb Greenberg kicked off an interesting discussion today when he said that it took “a lot of guts” for Wedbush Morgan analyst Michael Pachter to go on CNBC today with his bearish view on Netflix, ahead of its earnings announcement this afternoon. David Wilkerson has the details of Pachter’s analysis, complete with the context:
With the stock hovering in the $80 range in April 2010, Pachter downgraded the shares to underperform from perform, with a target price of $73. Even after seeing the stock zoom into the $240s, Pachter is sticking to his rating, and a target price of $80.
That’s a very aggressive price target: Pachter’s saying that Netflix is set to lose more than two-thirds of its value, despite having a subscriber base of some 23 million Americans. But is it really a bold move for Pachter? Does it take a lot of guts for him to say this, and if so, why?
Part of the answer to that question is buried in a market symmetry: the long bias of investors is matched by a bullish bias on the analyst side. Most investors are long-only, and even the ones who go short tend to follow a 120/20 or 130/30 strategy: they nearly always have many more long positions than they have short positions. As a result, the market as a whole is already biased against anybody with a “sell” recommendation.
And when it comes to screamingly-hot stocks like Netflix, that’s even more true. Such stocks tend not to be held as part of a long-term portfolio of diversified names; they’re held by momentum traders who want to buy high and sell higher. These people tend to be pretty emotionally invested in their trade and in the sentiment which is driving it, and they can be quite aggressive towards anybody who might damage that sentiment.
On top of that, Wall Street does have a habit of boiling everything down to a right/wrong duality: if you say that a stock will go down, you’re right if it does, and wrong if it doesn’t. The intelligence of your analysis, or the idea that all these things are probabilistic rather than certain, rarely even gets lip service. This is why you see so much technical analysis on Wall Street: it makes no intellectual sense at all, but it works just as well as — or even better than — fundamentals-based analysis. (Which, admittedly, isn’t saying very much.) And that’s all that matters.
There’s also an inability for anybody to appreciate the difference between “buy/sell” on the one hand, and “long/short” on the other. A “sell” rating is not the same as a recommendation to go short. Selling your NFLX at $250 is a risk-averse move: you’re taking a volatile and overvalued stock, taking what are probably enormous profits, and saying that you’d rather sell too early than too late. Shorting NFLX at $250, by contrast, is a highly risky move which can hurt you very badly indeed. Yet when an analyst says “sell”, everybody starts talking about his “short position”, and saying things like “how’s your Netflix short coming along, Mikey?”.
One thing that’s certain about a “sell” rating, of course, is that it’s going to annoy the management of the company in question. And this is where the distinction comes in between issuing a “sell” rating on a privately-circulated report, on the one hand, and loudly proclaiming your analysis on CNBC, on the other. The television audience isn’t just sophisticated investors: it’s a much broader public than that, and corporate management hates even thinking about the idea that their company is being trashed in front of a huge audience. So if you’re going to present a bearish case on TV, be prepared to lose much if not all of your access to management.
If you make a very public bearish case, on TV, for a very visible consumer stock with lots of name recognition, that’s about as far as you can stick your neck out if you’re an analyst. That’s what Greenberg was referring to: yes, on one level it’s Pachter’s job to have an opinion on Netflix and be willing to be called on it if CNBC calls him up. But it’s easy to see why most analysts try hard never to put themselves in that kind of situation. “Clients will always be pissed if you’re wrong,” Greenberg told me in a short conversation this afternoon. “A long guy against the crowd is a value investor. A short is taking his life in his hands.”
Finally, if Netflix does fall dramatically from here — if Pachter’s call turns out to have marked the very top of the Netflix market — he’s still not going to be a hero. He’s been wrong for long enough, now, that people can just say that he was sure to be right eventually. And they’ll probably credit their own perspicaciousness if they followed Pachter’s advice, rather than giving him the credit he deserves.
So well done to Pachter for sticking to his convictions. I hope he doesn’t expect to gain much from them.
Update: I just got a great email from someone who wishes to remain anonymous:
a. In Pachter’s specific case, he’s been down on Netflix for quite a while, so it’s not exactly a significant amount of courage to go out and keep reiterating it. Whatever bridges there are to burn with a company are already burned by now, and, he’s just at the point of re-re-re-reiterating or capitulating.
b. The incentives for a guy at a (relatively) smaller shop can be a bit different – you make a name for yourself by standing out more. Whereas the bigger-shop guys have more of an incentive to limit how crazy their calls get.
c. From my perspective, there is minimal need for a research analyst to actually get his calls right. The majority of his compensation is driven by how useful he is to institutional clients. Fidelity is not going to outsource their investment decisions to a bank (for the most part), so they don’t really care what your rating or target is. They just want you to know everything there is to know about a company when they call. Some analysts are good stock pickers and they end up at hedge funds eventually. Many successful analysts are not.
d. As an outgrowth of c, I think it can be a disservice to retail investors to put some analysts on tv. They’re better at setting the scene than telling someone who owns a couple hundred shares of a stock what to do with it (setting aside whether that person should be holding/trading individual stocks to begin with).
e. Also, an analyst has to have a rating on every stock he covers. But he might only have a strong opinion on one, or a small handful. Good luck getting that context if you aren’t a paying client.