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Picking Stocks: Profits from the Prophets?

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Analysts' recommendations might prove useful when buying stocks for the long-term, but questions arise as to the effectiveness of professional recommendations in choosing stocks with superior returns. Are you playing a loser's game by using the picks of the prophets for trading strategies?

Introduction

Should investors follow the smart money?

The two biggest limitations for the vast majority of individual investors are that they do not have the time or the investment training to conduct the kind of analysis they want. Professional investors overcome these two limitations. They have the time and resources to conduct rigorous and relatively complete research on firms and their prospects. In fact, that is their job! Many investors turn to these professionals, or prophets, to get good investment recommendations. Yes, investors should follow the smart money. But who represents the smart money?

Analysts

Stock analysts' recommendations permeate the financial media in TV, on the Internet, and in newspapers. Their job is to make predictions and recommendations. Security analysts are usually employed by brokerage firms and investment banks to generate information and recommendations about firms and industries. Their clients are as diverse as individual investors, mutual funds, hedge funds, and pension funds. As a group, analysts are highly trained in finance, economics, and accounting. In addition, an industry trade group oversees the popular designation, Chartered Financial Analysts (CFA). The CFA designation is to the investment industry what the better-known CPA is to the accounting industry. One must pass three rigorous exams and have three years of investment industry experience to earn the CFA. The rewards are great for the successful analyst. Average salaries for analysts rose from $400,000 in the mid-1980s to nearly $3 million at the end of the 1990s. The star analysts make much more.

Analysts forecast many things about firms, such as earnings, dividends, and sales. However, the recommendation to buy or sell stock is the decision most followed by investors. There are several recommendation systems used by analysts to express their belief about the future of a certain stock. Each system uses a slightly different vocabulary, but most systems can be expressed in five categories which I will call Strong Buy, Buy, Hold, Sell, and Strong Sell. Are the recommendations of analysts useful to the investor?

Investors are most interested in firms that receive a Strong Buy recommendation. One study examined the performance of over 360,000 recommendations by 4,340 analysts for the period 1985 to 1996.1 An investor may follow the analysts' recommendations each day. That investor would make changes in the portfolio each day by purchasing new Strong Buy recommendations and selling downgraded firms. This would require a daily rebalancing of the portfolio, but it would mean that the portfolio always reflects the consensus of the analysts.

The return an investor would have earned with this investment strategy is shown in Figure 5.1. This strategy resulted in beating the stock market by 4.29% per year. This is quite good. Clearly, the analysts are recommending good stocks. However, the daily additions and subtractions in the portfolio would take a considerable toll. Because this strategy requires trading so frequently (portfolio turnover of 450%!), the transaction costs devastate the returns. After transaction costs, the investor underperforms the market by 3.59%. To reduce the frequency of trading, the investor might trade on a monthly rather than daily basis. The returns of this strategy beat the market by 2.33% before transaction costs but underperformed the market by 3.21% accounting for transaction costs.

Figure 5.1Figure 5.1 Annual performance (beating the market) of buying the Strong Buy recommendations of securities analysts. The first four columns are for the period 1985 to 1996. The last two columns are for the period 1996 to 1999 and 2000, respectively.

There are two important points to learn. The analysts appear to have picked good firms, but trading on the recommendations is not profitable. Therefore, an investor looking for a stock to purchase might use analysts' recommendations to help chose one. However, frequent trading from the recommendations is a losing proposition.

In addition, certain conditions in the analyst environment may have changed, which makes their recommendations less useful. Researchers of the previous study conducted a follow-up study that included the years 1996 to 2000.2 The results are quite striking. First, analyst recommendations of Strong Buys did not perform quite so well from 1996 to 1999. As the figure shows, the category beat the market by 2.03% annually compared to the 4.29% in the earlier years. The year 2000 was a disaster. The Strong Buy picks underperformed the market by an astonishing 31.69%. The stocks that were recommended as a Strong Sell in 2000 beat the market by 48.7%. What was so different about 2000? This is the year that the tech stock bubble collapsed. It appears that analysts didn't predict the dramatic change in the stock market.

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