The Questionable Value of Analysts

Since we brought up the brewing I/B/E/S Analyst ratings scandal, we thought this an opportune time to revisit some interesting observations of Rich Bernstein via Barron's Alan Abelson.

We discussed that some analysts at major firms have been "tweaking" and "correcting" their prior ratings and up/downgrading history. This was done apparently to improve their historical track records. Of course, not everyone did this; the professors who authored the study found "only" 54,729 non-random, ex-post changes out of 280,463 (19.5%). Based on those numbers, we can presume many of the analysts who participate in the I/B/E/S rating system are ethical - or at least were unwilling to game the system or make changes to ratings after the fact.

A quant study from Merrill's Bernstein - released prior to this news breaking - takes a different, contrary to the crowd tack. It turns out that the stocks in the S&P 500 with the least analyst coverage outperformed the rest in 2006 - and quite handily, also:

Before 2006 slips away further into the mists of history, we might pass along some conclusions about that surprising, rewarding and rambunctious year we found especially interesting. They're from the pen of Rich Bernstein, Merrill Lynch's chief investment strategist, who, despite that ominous title, is a sensible and knowing observer of the stock market.

More specifically, Rich addressed the question of what were the best performing investment strategies in '06 among the 40 or so tallied by the firm's quants, rather a logical subject for a leading brokerage house's No. 1 strategist. Why do we find it more than a little deliciously ironic that he discovered that the very best strategy was buying stocks with scant analyst coverage? Maybe it had something to do with the fact that, at last count, Merrill employed no fewer than 750 analysts in its global research network.

In any case, Rich asserts that the investor who concentrated on the 50 stocks in the S&P 500 that are followed by the fewest Wall Streets analysts wound up with a rousing 24.6% gain in the 12 months ended Dec. 29. That handily beats the quite decent 13.6% advance of the S&P 500, or, for the matter, the 14.6% rise by the index when calculated on an equally weighted basis.

Which - how could it not? - brought to mind that wonderful piece of advice rendered years ago by that famous curmudgeon and demon investor Gerald Loeb as to what ordinary folks investing in equities ought to remember about security analysts: "In bull markets, you don't need 'em; in bear markets, you don't want 'em." (emphasis added)

Fascinating stuff. Other strategies that outperformed the S&P500's 13.6% gains: Stocks that had low price-to-cash-flow multiples (23%), and those with a high dividend yield (21.7%).

Weakest strategy? Growth did a little better than cash (5.7%) - "despite the consensus at the beginning of the year that 'growth would outperform value in 2006, investors who stayed with value and out-of-favor stocks' racked up the best returns."

My question to Bernstein & Co. is this: How has this approach worked in the past? Is it only a 2006 phenomenon, or has it been successful in years prior?

So while we ponder what this brewing ethical quagmire of analyst ratings means to the industry and to investor confidence, there may be another lesson embedded in this for stock pickers: Look for stocks off the beaten path, and away from the best known, best covered names.

Source:
Skeleton at the Feast
ALAN ABELSON
Barron's Monday, January 8, 2007
http://online.barrons.com/article/SB116804493030668807.html

Comments

[Sonia Mirza:]

RE: "another lesson embedded in this for stock pickers: Look for stocks off the beaten path, and away from the best known, best covered names. "

I've always wondered how the people that take TV celebrities' opinions (think CNBC Fast Money/Mad Money) actually make people real (in economic terms) money. If everyone who is watching the show, buys what XXX tells you to buy, how do you have an advantage? Yes we all know JNJ and PG are great. But what if I want a return that doesnt putter with the market and I want to surpass? Finding what will be the next hit with analysts has always fascinated me - and I guess my gutt has always worked for me, but I wonder how others get in on the best investments before they make the news...


I do look at the rankings, but in the end my decision is based on the ideas in my head, and what I believe the trajectory of the company/market is vs what the rankings imply. Recall, people called Warren Buffet crazy for betting that people would always read newspapers when the internet age was exploding...

2007 Mar 16 09:43 PM