Stocks With Wide Ranging Earnings Estimates Are Generally Overvalued

by: Paul Kedrosky

While equity analysts' estimates generally cluster eerily around a single figure for any given quarter or fiscal year, sometimes that is not the case. Matter of fact, sometimes analyst estimates seem more like they're for different stocks, with giant differences across analysts.

A new research paper drives uses that bit of strangeness to look at the relationship between over-broad analyst estimates and subsequent stock performance. As is reasonably well known, stocks with wide-ranging earnings estimates tend to be over-valued. But why? Here are the authors on the subject:

This apparent overvaluation might be explained by the finding that although analysts disagree more about unfavorable earnings- related news (Ciccone (2003)), the full extent of unfavorable news is withheld from the market (McNichols and O’Brien (1997) and Hong, Lim, and Stein (2000)). Consequently, the prices of such stocks end up being excessively optimistic but correct downwards as information about the current year’s earnings gradually becomes available. Diether, Malloy, and Scherbina (2002) show that the underperformance of high-analyst disagreement stocks continues for six months on average.

Nifty, but can you make money from the anomaly? Excluding trading costs, yes, but once you factor those in, then the returns from shorting analyst disagreements become very small indeed. Nevertheless, as a factor in a multi-factor stock model, it is useful if you're trying to model near-term price performance.

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