Blindly following stock tips from Wall Street analysts is a bad idea, says Marc Lichtenfeld in The Smart Profits Report. For most investment bankers, drumming up business and trading commissions is more of a priority than getting every forecast right. Finding a quality company that Wall Street ignores is a surefire way to book considerable profits. More from Marc…

People ask me all the time why I like to bet against Wall Street analysts. After all, these analysts are smart people with MBAs from some of the top schools in the country. They work a ton of hours and are paid handsomely for it. Of all people, they have to know what they’re talking about, right?

And here’s how I answer: some do and some don’t. But that’s really not the right question to be asking in the first place. In order to get ahead in the stock market, you have to first understand how the game is played. This is one area where winging it definitely is not the best of strategies.

Knowing Your Opponent

See, analysts are mainly interested in one of two things: drumming up or keeping investment banking business and trading commissions. If you only take one thing away from this column, let it be that.

The firms don’t care if an analyst is wrong 100% of the time, just as long as his reports generate trading commissions and the companies he covers give the firm their banking business. On the flip side, an analyst who is a prophet when it comes to predicting stock prices will be collecting unemployment if he is not converting his research into trading or banking revenue.

Now of course there are some exceptions. Firms do exist that don’t have investment banking departments, and generally their research is unbiased. But otherwise, it’s best to be cautious about any recommendations those “expert” analysts send out to the masses.

When I was an analyst at one such independent firm, we were trained to only write about companies if our opinion went against the consensus. At this company, I worked for two of the greatest contrarian investors of the past twenty or so years, and I’m still a firm believer in this tried and true formula.

The Art Of Knowing When To Hold and When Not To

Now, keep in mind, you can’t simply buy everything Wall Street tells you to hold or sell and sell everything they recommend you should buy. Making profits is rarely that easy. You still have to do the work finding the quality companies on which Wall Street has soured or has yet to discover. You also need to figure out which Wall Street darlings are headed for trouble.

The reason is simple: These analysts still carry a lot of weight. When they upgrade a stock to buy, both individual and institutional investors take them for their word and purchase the stock. And that adds a lot of upward pressure.

If you’re in a stock that is out of favor – let’s say one that has 5 holds and 2 buy ratings – when an upgrade or new buy recommendation comes out, the renewed interest in the stock should send prices meaningfully higher.

However, if you’re in a stock that is already loved on the street – let’s assume 8 buys and 1 hold – that one upgrade to buy, probably won’t generate a lot of new activity.

In other words, you want to get in before the rest of Wall Street piles on and drives the bandwagon in the right direction.

This doesn’t mean that you can’t make money with stocks that the consensus rates a buy. But the real money is made when out of favor stocks become in favor.

They All Said This One Wasn’t Going Places…And Look What Happened

Here’s an example: Back in 2005, I initiated coverage of Costco (NASDAQ:COST) with a buy rating. Hardly a controversial call, right? They’re the most well run and well loved of the warehouse stores.

Even Wall Street acknowledged as much, though the consensus rating was a hold (meaning sell in analyst speak). The analysts believed at $43 and change, the stock didn’t have much upside because Costco caps its margins on items it sells at 14%.

I argued that Wall Street did not appreciate the strength of the Costco brand to drive traffic and revenue. Additionally, shoppers had now accepted and were increasingly choosing Costco’s higher margin in-house Kirkland brand.

From the time I put out my report to today, Costco is up 45% (it had been up as much as 72%) versus the S&P 500, which has gained 4.5% (and 26.8% at its high) in the same period.

Incidentally, I don’t think Costco is a good buy today. Rising wholesale prices will crimp its margins.

I’ve seen this pattern repeat itself throughout my career.

Pick quality companies that Wall Street ignores and it’s practically guaranteed that you’ll make money.

And the best part? You won’t have to put in 80-hour workweeks to do it.

Source: Why You Don’t Want to Follow the Wall Street ‘In-Crowd’