Accounting
Research by
Brad Barber
University of California, Davis
Reuven Lehavy
University of California, Berkeley
Maureen McNichols
Marriner S. Eccles Professor of Public and Private Management
Brett Trueman
University of California, Berkeley
Can Investors Profit from the Prophets? Consensus Analyst Recommendations and Stock Returns
Brad Barber, Reuven Lehavy, Maureen McNichols, and Brett Trueman
GSB Resarch Paper 1541 (PDF format ), May 2000
Perspectives on Accounting Research at Stanford Business School, July 2002
FOR FURTHER INFORMATION: Helen K. Chang, 650-723-3358, Fax: 650-725-6750
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email research_papers@gsb.stanford.edu
Following Analysts' Advice Can Pay Off
March 1999
STANFORD GRADUATE SCHOOL OF BUSINESS—Can investors profit from the prophets? In some cases, yes, says the Business School's Maureen McNichols, who has been studying the accuracy and bias of securities analysts. In her latest research, she looks at what would happen if investors strictly followed analysts' advice, buying stocks they recommended and shorting issues they shunned.
Working with three colleagues, McNichols, an associate professor of accounting, analyzed the average recommendations of stock analysts between 1986 and 1996. "There were two striking findings in the paper," says McNichols. First, the authors found that analysts were, in fact, good at picking stocks and created profits for investors. The analysts achieved that value by identifying stocks that had been mispriced by the market. By taking into account information such as an imminent product development that was not widely known, they could provide investors with profitable investment recommendations. Indeed, the researchers, who include Brad Barber at UC-Davis as well as Reuven Lehavy and Brett Trueman at UC-Berkeley, found that an investment strategy based on the average recommendations of securities analysts yielded a yearly return 12 percent higher than a benchmark stock index akin to the Standard & Poor's 500.
More intriguing is the authors' second finding: A significant portion of the extra value delivered by analysts came from small and medium-sized companies. They discovered that the market was much slower to digest information about the smaller firms. "Here's this public information that you should buy this stock or sell that stock and yet prices among small and medium-sized stocks don't reflect that within a day or two," says McNichols. "People aren't responding because they are lesser known stocks. It may take 15 to 30 days for prices to reflect that information because of the trading volume that's needed to move the price." The fact that prices don't adjust immediately on certain types of stocks also gives investors more time to take advantage of the analysts' recommendations.
But can investors actually earn extra profits by buying stocks with the most favorable recommendations and selling short those with the least favorable recommendations? Unfortunately, the answer is no--at least for small investors. "Transaction costs can wipe out any gains investors might have made," McNichols explains. However, some investors who are planning to invest and incur trading costs anyway, such as institutional investors, could benefit from such a strategy. "They are better off taking into account analysts' consensus recommendations in their investment decisions," says McNichols.
In other research, McNichols investigated the concern that analysts have a conflict of interest when it comes to covering stocks of companies that their banks also serve as underwriting clients. She found that analysts did publish more favorable recommendations for companies that their bankers were about to take public, but that there was little difference in the announcement or in subsequent returns to their recommendations relative to those issued by unaffiliated analysts. However, hold or sell recommendations by affiliated analysts sent a much more negative signal to investors than the same advice on an unaffiliated stock. Either way, it did not appear that investors suffered from following those recommendations. In a third study, McNichols showed that analysts usually follow better-performing stocks and are more likely to ignore troubled ones. They don't cover stocks that are doing poorly because trading, which generates profits for the brokerage, is usually low on lackluster issues.
All of these studies are important to accounting standards setters, who base their regulations partly on the quality of information available about any given company. Since companies with bad news can be reluctant to advertise it, policy makers should recognize that investors generally are starved for negative information and try to offset that with solid reporting rules.
—by Barbara Buell
