Analysts Explained

Why did Goldman Sachs downgrade Forest Labs to a sell right after the company beat the Street's consensus earnings estimates for the fourth consecutive quarter? Why downgrade Forest Labs at all?

We went over the arguments in Goldman's downgrade and found them wanting on last night's show. If you want to know the reasons the Goldman analyst—we don’t name names—gave for downgrading Forest Labs , then read the Madcap Recap. But by themselves, those reasons won't tell you why Goldman is calling this stock a sell. There's more to it than that.

So what else explains the downgrade? Remember, analysts don't just cover one stock, they have an entire coverage universe. Typically that universe is a small one, a handful of stocks in the same sector. The pharma analyst at Goldman Sachs who downgraded Forest Labs covers six other stocks: Bristol-Myers, Eli Lilly, Merck, Pfizer, Schering-Plough and Wyeth. That matters.

One of Jim’s rules from Stay Mad For Life: Get Rich, Stay Rich is that analysts tend to be either too bearish or too bullish on a given sector. The reason? They usually only cover one sector, and it looks bad, fishy even, if they rate the stocks they cover as all buys or all sells. You also look lazy if you give virtually every stock you cover the same rating. That's why most analysts endeavor to have some buys, some holds and some sells.

But we know that 50% of a stock's performance is determined by its sector. So there might be times when the right call is to be bullish on an entire group, but many analysts will still try to have some sells and some holds since that's how they maintain their professional credibility.

Right now it actually makes a lot of sense to own drug companies because we're in a hideous recession and the pharmaceutical business isn't economically sensitive. When consumers try to rein in their spending, they don't cut back on things like medicine. That means drug companies can deliver consistent earnings while other industries stumble. Investors flock to these names when the wheels of commerce break down, and historically that's caused drug stocks to outperform during economic slowdowns and recessions.

Knowing all this, let's take another look at this analyst's downgrade of Forest Labs from neutral to sell. Before the downgrade, Goldman's large-cap pharma analyst rated two stocks as buys, Bristol-Myers and Wyeth, and rated the rest neutral. That looks to me like an analyst in need of something to downgrade.

Now I'm sure this analyst believes every word he wrote about Forest Labs. We have no reason to think that this person is anything other than completely honest, and I'm not trying to suggest anything to the contrary.

I am suggesting that you assess the sell rating on Forest Labs within the context of all the stocks this analyst at Goldman covers. When you look at it that way, does sell mean “sell,” or does it mean, “out of the seven drug stocks I cover, Forest Labs is the one I like the least”?

I think the latter, and that makes a big difference.

Cramer's charitable trust owns Bristol-Myers Squibb.

Cliff Mason is the Senior Writer of CNBC's Mad Money w/Jim Cramer, and has been that program's primary writer, in cooperation with and under the supervision of Jim Cramer, since he began at CNBC as an intern during the summer of 2005. Mason was the author of a column at during 2007, which he describes as "hilarious, if short-lived." He graduated from Harvard College in 2007. It was at Harvard that Mason learned to multi-task, mastering the art of seeming to pay attention to professors while writing scripts for Mad Money. Mason has co-written two books with Jim Cramer: Jim Cramer's Mad Money: Watch TV, Get Richand Stay Mad For Life: Get Rich, Stay Rich (Make Your Kids Even Richer). He is 100% responsible for any parts of either book that you did not like.

Mason has also had a fruitful relationship with Jim Cramer as his nephew for the last 23 years and will hopefully continue to hold that position for many more as long as he doesn't do anything to get himself kicked out of the family.

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