Can Investors Profit from the Prophets? Consensus Analyst Recommendations and Stock Returns

In this paper we document that stocks highly recommended by analysts outperform the market, while those that are unfavorably recommended underperform. Our findings are based on an extensive analysis of over 360,000 analyst recommendations from 269 brokerage houses over the period 1986-1996. We show that strategies of purchasing the stocks with the most favorable consensus (average) recommendations or selling short those with the least favorable recommendations, in conjunction with daily portfolio rebalancing and a timely response by investors to changes in consensus recommendation, yielded and annual abnormal gross return of more than 4 percent. Less frequent portfolio rebalancing or a delay in reacting to consensus recommendation changes diminished the abnormal returns; however, they did remain significant for the least favorable rated stocks. We also show that quite high trading levels are required to capture the excess returns generated by the strategies we analyze, entailing substantial transactions costs and leading to abnormal net returns for these strategies that were not reliably greater than zero.