Our Take on the Most and Least Favored Sell-Side Recommendations

by: AFG Indexes

There are several articles and studies around the finance industry that talk about the value of sell-side analyst ratings or the lack thereof. Most of the studies provide a negative view of the accuracy of ratings from sell-side analysts and bring to light the many potential problems associated with sell-side analysts and their ratings including conflicts of interest with the firms that employ them as well as their tendency to appease management teams who provide them with information not available to the public by providing favorable ratings for those firms.

Some other problems associated with sell-side analyst ratings include:

1) Buy recommendations outnumber sell recommendations some speculate for the purpose of making management happy.

2) Analysts often downgrade firms after negative news has already hit public eyes.

3) Unable to purchase the stocks that they cover, no “skin in the game”

4) Analysts often find comfort in being a part of the majority and often times fall victim to groupthink.

5) Compensation analyst’s receive has been found to be tied to the investment banking business the analyst generates.

With so many causes for concern, it is no surprise that buy-side professionals frequently question the value of sell-side analyst ratings and place a high value on quality independent analysis from independent research firms that are free of many of the conflicts of interests that plague sell-side research. Although less controversial for the most part, independent analysts also fall victim to some of these conflicts as some have been known to provide favorable ratings in order to preserve relationships with management teams who keep them on the inside track.

Sell-side analysts do a good job of framing the issues and telling a complete and detailed story of the companies that they cover, though according to numerous studies they do not do a great job of valuing securities. It is difficult to determine whether independent stock research is more useful than sell-side research as both have advantages and disadvantages, it is good however to have access to independent research free from conflicts of interest to provide a view from “off the street”.

The Applied Finance Group is focused on valuing securities using an unbiased and consistent approach to provide our clients quality investment advice. Our Buy and Sell ratings (performance below) have delivered consistent results with a significant spread achieved between companies that we label as attractive and those that we label as unattractive on an annualized basis.

We have taken a list of companies from an article on Bloomberg that have the largest gaps between their market price and their average target price estimates to determine which sell-side recommendations are in-line with our view of the company and which companies we think do not belong on the list. The first chart highlights the companies with the largest positive gap percentage between market price and estimates (most favored stocks) and the second chart highlights the companies with the largest negative gap percentage between market price and estimates (most out of favor stocks). We have overlaid our analysis of the stocks contained within each table by highlighting the companies based on our view of the attractiveness of each stock. Companies highlighted in Green are those that we label as attractive, companies in Red are those that look unattractive and the companies in Black are those that we have a neutral opinion of to provide an idea of how we view the companies on this list.

In the future we will compare the performance of each list to the performance of the companies that we have labeled in each category to see how our performance fares against the sell-side.

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source: www.economicmargin.com

The backtest results below display the performance of companies that we have identified as buys, sells and holds since 1998. As you can see by using AFG’s Economic Margin framework and valuation techniques there is a significant spread achieved between those companies that we identify as buys or sells.

AFG Buy/Hold/Sell Results - 9/25/1998 - 9/24/2010

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Disclosure: None