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Shot in the dark - Eureka Report Article

November 5, 2007
Shot in the dark
By Scott Francis

PORTFOLIO POINT: Stockbroker recommendations are proving to be a hard sell, with a high percentage of research failing to deliver the returns promised to investors.

How useful are stock recommendations to investors? Considering the attention garnered by brokers for 'buy' or 'sell' recommendations, it's a very important question. Moreover, if you are a regular customer of any stockbroker, you are at the very least subsidising the cost of these analysts' recommendations through the brokerage charges you pay on your share trading.

As we move into a more difficult investing environment with rising inflation and higher funding costs, stock picking becomes much more important. For most 'stock pickers', brokers' reports with their accompanying recommendations are crucial ... but do they work?

To my surprise, relatively little work is available on the subject. In this article, I focus on two key studies - one looking at the returns from Australian analyst recommendations in both good and bad markets, the other looking at a contest between sharemarket analysts and a dartboard published in the Wall Street Journal. In both cases the results for the analysts are not at all promising.

In Australia the paper Prophet's During Boom and Gloom Downunder was published in the Global Finance Journal in 2005. It was written by Sarah Azzi and Ron Bird, from the University of Technology, Sydney.

The paper found that analyst recommendations, "if anything, have negative value with the exception of those made in relation to low momentum growth stocks". The paper used data from the Institutional Broker Estimate System (IBES), with a sample that extended from April 1994 to March 2003. Interestingly, this period experienced two distinctly different periods of market performance - being a period of strong market returns from 1994 to 1999, and then a period of poor returns from 2000 to 2002. The authors studied these two periods separately, to see how analysts performed in a strong market and a poor market.

Here are the key results:
Over the entire period of the study (1994 to 2003), shares with both 'strong buy' and 'buy' recommendations underperformed the average market return. Over the poor period of market returns, analysts appeared to perform even worse. The average 'sell' recommendation outperformed both 'strong buy' and 'buy' recommendations over the poor period of market returns.

The authors of the report summed this up in their conclusion by saying that, "analyst recommendations seem to provide minimal insight into better performing stocks".

There was a second aspect to this study, which looked at the changes to analyst recommendations. The authors found that "recommendation changes are identified as possessing superior predictive skill". That is, they found evidence that recommendation changes did hold useful information for an investor.

As an aside, in the study, recommendations were sorted on a five-point scale:
1 - Sell
2 - Underperform
3 - Hold
4 - Buy
5 - Strong Buy

The average recommendation over the period was a 4 - a buy. This seems inconsistent with what we should expect. You would expect over any given period that about half the shares in the market would provide above-average performance and about half below-average performance. Having an average recommendation of 'buy' seems inconsistent with reasonable expectations of about half the shares in the market providing above-average returns, and about half providing below-average returns. This provides fuel for those that say the hardest word for a stockbroker is 'sell'.

The Dartboard and the Analysts

An interesting paper by Gary Porter, published in the Journal of Applied Finance in 2004, looked at a long-standing stock tipping contest between prominent US equity analysts and a dartboard.

The competition was run in the Wall Street Journal, and every month eight highly credentialed Wall Street analysts nominated their best stock pick - compared to eight Wall Street Journal staffers throwing darts at a dart board. Gary Porter, an assistant finance professor in the US, analysed the results of this contest over the period that it ran - from January 3, 1990 to September 12, 2002.

Using closing prices on the day of each publication, an investor who contributed monthly to a portfolio that mirrored all recommendations - investing $1 in each of the recommendations each month - would have found their portfolio value at the end of the trial would be:
  • $1,091 using the recommendations of the professional investors and;
  • $1,368 using the recommendations of the darts.

This was summed up by the author as "investors who bought and held the securities selected by the darts achieved the greatest wealth". The paper also looked at how the analysts had performed over the bear market decline (defined in this paper as being May 31, 1999 to August 31, 2002) and the author found that "the darts outperformed the analysts ... during the recent market decline". In the end it's not that dartboards, astrologers or even school kids are that good, it's just that brokers are not so hard to beat. They get it wrong an awful lot of the time, and a bias towards 'buy' recommendations underpins this outcome. At least now we have a recommendation.


We need to be very careful summarising two substantial papers in 800 words; however the combined findings suggest that, at the very least, scepticism toward the predictive ability of sharemarket analysts might be healthy.