Analysts Prove Hazardous as Contrarian Stocks Surge

Following the advice of equity analysts may be perilous for your profits.

Companies in the Standard & Poor’s 500 Index that analysts loved the most rose 73 percent on average since the benchmark for U.S. equity started to recover in March 2009, while those with the fewest “buy” recommendations gained 165 percent, according to data compiled by Bloomberg. Now, banks’ favorites include retailers and restaurant chains, the industry that did best in last year’s rally and that are more expensive than the S&P 500 compared with their estimated 2011 profits.

Investors who look at the analysts as a contrary indicator are buying shares of utilities, which pay the highest dividends after telephone stocks, and banks, whose earnings are likely to grow three times as fast as the S&P 500 this year. Don Wordell, a fund manager at Atlanta-based RidgeWorth Capital Management Inc., says equities that Wall Street firms rate lowest are more likely to beat the market.

“When you have a stock that has 15 analysts covering it and it has 15 buys, I can’t imagine it has much outperformance left,” said Wordell, whose $1.64 billion RidgeWorth Mid-Cap Value Equity Fund topped 98 percent of peers in the past five years. “You’ve got a stock that has 15 sells on it, you’re set up there to have some strong outperformance.”

The S&P 500 completed the sixth straight weekly advance on Jan. 7. It has gained 88 percent to 1,271.50 since March 9, 2009, Bloomberg data show. The index slumped 0.1 percent to 1,269.75 today.

Netflix, Cummins

The benchmark index for American stocks rallied 13 percent in 2010. Consumer shares such as Netflix Inc., the Los Gatos, California-based movie service that posted the biggest gain on the S&P 500, rising 219 percent, led the advance, along with industrial companies like Cummins Inc., the Columbus, Indiana- based engine maker that advanced 140 percent.

Analysts said health-care and technology companies would win in 2010. Instead, they had two of the three smallest rallies among 10 industries in the S&P 500, gaining less than 10 percent. The stocks analysts liked least, banks and real estate firms, rose 19 percent and 28 percent, respectively, in 2010.

S&P 500 companies with the most “buy” ratings gained 8.7 percent in 2010, while the ones with the fewest jumped 20 percent, the data show. Bloomberg assigns each analyst rating a number ranging from 1 for “sell” to 5 for “buy.” For this article, stocks with at least five ratings on Dec. 31 were divided into three groups by average rating. Only rankings from analysts who still cover the companies were counted.

Stimulus Spending

The Federal Reserve’s unprecedented stimulus, including a program to buy $600 billion in bonds, to lower unemployment and boost growth spurred stocks whose earnings are most tied to the economy, such as Cleveland-based iron producer Cliffs Natural Resources Inc., which gained 69 percent. Earnings for S&P 500 companies rose 32 percent in 2010, analysts estimate, the fastest growth since 1994.

Tony Butler, a New York-based pharmaceutical analyst for Barclays Plc, told clients to buy Pfizer Inc. and Whitehouse Station, New Jersey-based Merck & Co. last year. New York-based Pfizer, the largest U.S. drugmaker, slipped 3.7 percent in 2010, while No. 2 Merck dropped 1.4 percent.

“You scratch your head and wonder, ‘Which part of this am I missing that the market is getting right?’” Butler said. His picks generated a 13 percent return in the past year, beating the average 8.9 percent gain from analysts following the industry, according to data compiled by Bloomberg.

Health-Care Miss

Analysts recommended health-care stocks on speculation the government would fail to pass legislation overhauling the industry, according to Butler. U.S. President Barack Obama signed his health-care policy into law on March 23, imposing fees on drugmakers and mandating insurance coverage.

Banks have been among the lowest-rated stocks in the S&P 500 even as they gained 172 percent since the rally began in March 2009. Sixteen lenders in the index may report average earnings growth of 44 percent in the 2011 as business recovers from the worst financial crisis since the Great Depression, forecasts compiled by Bloomberg show.

An improving economy and fewer write-offs for bad loans led to a surge in regional bank stocks last year, said Kevin St. Pierre, an analyst at Sanford C. Bernstein & Co. He recommended shares of Zions Bancorporation, a Salt Lake City-based lender that jumped 89 percent in 2010. The company started last year as the eighth lowest-rated stock in the S&P 500.

‘Easy and Safe’

“Throughout most of ‘09 and early 2010, it was very easy and safe to be negative on the financials,” said St. Pierre in an interview from New York. “Many analysts in different sectors said, ‘I’m not going to catch these falling knives.’ Knives were falling all over the place at the end of ‘09.”

Following St. Pierre’s recommendations in the past year would have generated a return of 17 percent, exceeding the 1 percent average increase from analysts following the industry, data compiled by Bloomberg show.

Analysts couldn’t foresee that changes to financial regulations would threaten profits at larger lenders, driving investors to smaller ones, said David A. George, a bank analyst at Robert W. Baird & Co. in St. Louis.

“A year ago today, financial regulatory reform was not even on people’s radar,” said George, ranked fourth by returns among 34 analysts who cover Wells Fargo & Co., according to data compiled by Bloomberg. “Going into 2010, a lot of investors were positioned in big banks. With the increased political and regulatory scrutiny, you saw money come out of those names and into the regionals.”

Missing Gains

At the end of 2009, George had “neutral” ratings on Zions, KeyCorp, SunTrust Banks Inc., M&T Bank Corp. and Marshall & Ilsley Corp. Each gained at least 26 percent in 2010.

Analysts are also bearish in 2011 on S&P 500 utilities, which offer a collective dividend yield of 4.32 percent, according to data compiled by Bloomberg. That’s more than twice the 1.86 percent yield of the S&P 500. Only telephone companies, at 5.17 percent, pay more.

Merchant generators, which sell power in wholesale markets, will be hurt by falling natural-gas prices, while traditional regulated utilities are expensive relative to forecast profit, said Michael S. Worms, a New York-based utilities analyst at Bank of Montreal. Southern Co., the largest U.S. electricity producer by market value, trades for 16 times estimated 2011 earnings, compared with 13.4 for the S&P 500.

‘Almost Fairly Valued’

“The bottom line is gas prices are down, and they will hurt the merchants,” said Worms, who has a “market perform” rating on 25 of the 29 companies he covers. “On the regulated side, I guess you can say they are almost fairly valued.”

Priceline.com Inc. and Darden Restaurants Inc. are among the S&P 500 companies analysts favor most, helping give so- called consumer discretionary stocks the second-highest average rating among 10 industries in the index behind health care. The stocks rallied as the economy gained momentum and U.S. retailers reported higher-than-estimated sales in November.

The measure of 79 stocks including hotel operators and restaurant owners rallied 26 percent last year, exceeding gains from the index’s nine other main industries. The group now is valued at 1.1 times sales, the highest since 2000, according to data compiled by Bloomberg.

“Our main reason for optimism is that the economy has gained its footing and spending is picking up on the corporate side,” said Matt Arnold, an analyst at Edward Jones & Co. in Des Peres, Missouri, who has 10 “buy” ratings and 6 “holds” on consumer companies. “That could yield some improvement on the employment front and in consumer spending, which will find its way down to retailers.”

Unemployment Rate

Spending is unlikely to bounce back enough to help the stocks given that the unemployment rate is within 0.7 percentage points of the 26-year high set in October 2009, said Paul Lejuez, a New York-based analyst at Nomura Holdings Inc. U.S. payrolls increased 103,000 in December, compared with the median forecast of 150,000 in a Bloomberg News survey, Labor Department figures showed Jan. 7. The jobless rate fell to 9.4 percent, partly reflecting a shrinking workforce.

“With unemployment where it is, we are not out of the woods here,” said Lejuez, who has 11 “neutral” or “reduce” ratings out of 18 stocks and downgraded Gap Inc. to “neutral” from “buy” on Jan. 7. “There’s too much complacency out there in terms of people assuming everything is great.”

Priceline, the second-largest online travel agency, trades at 46 times reported profit, the most expensive level since 2004. The Norwalk, Connecticut-based company gained 83 percent last year. Analysts’ estimates show Orlando-based Darden, owner of the Olive Garden restaurant chain, will increase profit excluding some items by 13 percent this year, compared with the S&P 500’s projected growth of 14 percent.

“The problem with stocks that are loved by everyone is that there’s no one left to buy them,” said Paul Zemsky, the New York-based head of asset allocation for ING Investment Management, which oversees $550 billion. “It’s hard to make money if you’re in the consensus.”

To contact the reporters on this story: Matt Walcoff in Toronto at mwalcoff1@bloomberg.net; Lynn Thomasson in Hong Kong at lthomasson@bloomberg.net.

To contact the editor responsible for this story: Nick Baker at nbaker7@bloomberg.net.

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