With confidence in Wall Street analysts shaken, where can you turn for reliable investment recommendations?

Mark Hulbert thought the answer might be newsletters. He is the editor of a newsletter that ranks the performance of investment advisory newsletters.

But while some recent anecdotal information seems to favor newsletters, numbers show that over the long term, neither analysts nor newsletters are superior, he said in an article in the AAII journal.

Predicting recent events

In the recent past, analysts have made some miserable calls compared with newsletters, says Hulbert in the journal, which is published by the American Association of Individual Investors.

Of the 13 Wall Street analysts who were following Enron last November, Forbes reported that 11 were rating the stock a “buy,” and only two warned investors to be cautious with “hold” or “sell” recommendations before the stock plummeted.

On the other hand, among the newsletters that Hulbert tracks, six of the eight that were following Enron sold the stock long before the stock’s blowup and wrote about it so newsletter subscribers could do the same thing. One newsletter editor was so convinced that Enron was a bum deal that he was shorting it or betting that the stock would fall months before the company’s problems became common knowledge.

Likewise, the newsletter editors were wise to WorldCom, while most analysts apparently were in the dark or at least they didn’t make clear to investors and brokers that accounting landmines lay ahead. Hulbert notes that nine of 17 Wall Street analysts at the beginning of April rated WorldCom either a “buy” or a “strong buy.”

But of the nine newsletters that recommended WorldCom at the beginning of the year, six had either downgraded it or sold it outright by the end of March saving investors from the collapse of the stock. And during the first three months of this year, one newsletter gave investors a valuable tip to short the stock.

Newsletter writers aren’t timid about blasting stocks or telling investors to sell them. They make their money by selling advice.

Analysts, on the other hand, avoid using words like “sell” because the negative word alienates potential investment banking clients, who are more significant to securities firms than to individual investors.

A New York attorney general’s investigation recently revealed that Merrill Lynch analysts at the end of the 1990s were rating stocks “buy” while calling the same stocks “junk” in office conversations with peers. The practice of soft-pedaling, or avoiding negative recommendations, is widespread on Wall Street, and the New York investigation is continuing beyond Merrill.

Ups, downs of both

Yet research by University of California-Davis finance Professor Brad Barber suggests that investors may not be well served by ignoring analysts’ research altogether. He studied 14 years of analyst recommendations, dating back to 1986, and found that investors would have done well if they had purchased the analysts’ favorite stocks.

Barber focused on the favorite 20 percent stocks or those that a large number of analysts liked the most. He didn’t rely on “sell,” “hold” and “buy” labels, and focused on the consensus views of stocks. Year after year, the analysts’ favorite stocks were strong and would have provided an investor an annualized mean return of 18.8 percent. On the other hand, buying the stocks analysts least liked earned only 5.78 percent.

The research raises the question of whether analysts excelled primarily because large growth stocks happened to do well during that particular time. The best years for analysts were 1996 through 1999 the peak of the bull market and also a period when large, fast-growing stocks were exceptionally popular.

In contrast, the market changed dramatically in 2000, and so did the analysts’ performance. In 2000, as the stock market soured, stocks that analysts most disliked turned out to be the best investments providing a 48.7 percent gain, while the top picks plummeted 31.2 percent.

Meanwhile, Hulbert notes, the newsletters had the reverse performance.

The years 1996 to 1999 were the worst for investment newsletters, and 2000 was one of the best.

Hulbert thinks the varying performances may simply be a function of the types of stocks that the two groups specialize in.

Wall Street analysts tend to focus on large-company stocks, while newsletters tend to acquaint investors with smaller stocks. So, when large company stocks dominated the market in the late 1990s, the Wall Street analysts looked smart. And when investors started dumping large expensive stocks in 2000 and instead bought the small stocks they’d been ignoring in the late 1990s, the newsletter editors looked smarter.

Said Hulbert, “It is impossible to conclude that you should always pick newsletters over analysts, or vice versa.”