Contact: Barbara Buell at [email protected] or 650 723-3157
STANFORD GRADUATE SCHOOL OF BUSINESS
Can investors profit from the prophets?
In some cases, yes, says Stanford Business School's Maureen McNichols, who has been studying the accuracy and bias of securities analysts. Her latest research 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 analyzed the average recommendations of stock analysts between 1986 and 1996.
"There were two striking findings in the paper," says McNichols. First, they found analysts were in fact good at picking stocks and created profits for investors. They 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, analysts could provide investors with profitable investment recommendations.
Indeed, the researchers, who included Brad Barber at the University of California, Davis, as well as Reuven Lehavy and Brett Trueman at the University of California, 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 & Poors 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, who is associate professor of accounting. "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.
"Transactions costs wipe out any gains investors might have made," says McNichols. 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 has 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 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 the better-performing stocks and are more likely to ignore the troubled ones. They don't cover stocks that are doing poorly because trading, which generates profits for the brokerage, is usually low on lackl
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.
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