Research Analysts Add Value: Here's Proof

by: CFA Institute Contributors

By Jeremy Monk

What's more accurate: forecasts by research analysts or forecasts by management?

It turns out that post-event forecasts by analysts - specifically, those conducted after recent results or management guidance - are more on target than those of management, according to a study by AKRO Investiční společnost, a Czech investment firm.

In a reassuring conclusion for research analysts, the study found that analyst predictions were more accurate more frequently than management forecasts.

Moreover, if analysts can provide insight into tangible measures of value, then we can presume they are also able to offer insight into other, less tangible measures of value, such as management quality and industry outlook.

At a time when active asset management is the recipient of an ample share of bad press and many research departments are being downsized, these results should stand as a compelling counterpoint.

Analyst Forecasts Are More Often Closer to the Mark . . .

Reviewing the accuracy of annual forecasts of companies in the Nikkei 225 over the 11-year period between 2006 and 2016, the AKRO Investiční společnost study took advantage of an interesting feature of Japan's equity market: Listed companies provide updated annual forecasts whenever they release their quarterly results.

Forecast Accuracy Frequency: Management Guidance vs. Post-Guidance Analyst Forecasts

 Forecast Accuracy Frequency: Management Guidance vs. Post-Guidance Analyst Forecasts

Two measures of forecast accuracy were examined: The first compared the frequency with which post-event analyst forecasts proved more accurate than management guidance. Four key forecast variables were analyzed: sales, operating income, net income, and earnings per share (NYSEARCA:EPS).

These results are summarized in the table above. Regardless of which item on the profit-and-loss account was forecast, post-event analyst predictions were significantly closer to the final result than those of management. Overall, analyst forecasts were closer 57% of the time compared to management at 39%. Comparable accuracy was achieved 4% of the time.

With the occasional exception, this trend in favor of analysts' forecasts persisted over the entire period of the study.

And by a Significant Margin . . .

The second measure looked at the percentage the reported result deviated from the forecast - referred to as the "degree of surprise." The lower the percentage deviation, the more accurate the forecast. The median percentage deviation of forecasts from the actual result, or the level of surprise, is illustrated in the chart below.

Media Deviation from Actual Results

Median Deviation from Actual Results

Looking at sales forecasts, the median percentage surprise factor for management forecasts was 0.87%, 0.86% for the standard consensus forecast, and 0.73% for the post-event or analyst consensus.

What is most striking from the data is that the post-event consensus was the most accurate predictor of the final result, as demonstrated by its lowest percentage deviation, and was more accurate than either the standard consensus or management forecasts.

Moving down the income statement, while the overall forecasting accuracy diminishes, the degree of added value analysts provide increases. For example, the median level of surprise for management forecasts of EPS is 7.43% compared with 6.18% for analysts' post-event forecasts.

This difference in forecast accuracy is really quite large - remember, we are comparing the accuracy of forecasts prior to the final announcement. With results for the first nine months already released, the percentage difference in forecast accuracy for the 12-month results must then occur in the final three months of the year. To illustrate this point, assuming there is no seasonality in the quarterly results, for the analysts' 12 month EPS forecasts to be 1.25% more accurate, their forecasts for the final quarter must be approximately 5% (1.25% x 4) more accurate than those implied by the management forecast. An impressive result!

Timeliness Matters

The practical implications are clear:

  • In general, investors should use forecasts made post-event, meaning after the most recent results or management guidance.
  • Where no post-event forecasts are available, investors should focus on company guidance.
  • The least accurate forecasts are those made prior to recent results or guidance. If possible, these out-of-date forecasts should be completely excluded as they detract from forecast accuracy.

These common sense findings call into question the widespread use of standard consensus forecasts. In the second table, the standard consensus, which also includes older forecasts, is significantly less accurate than the post-event consensus. In other words, the timeliness of forecasts is more important than the inclusion of a large number of forecasts.

Part of the problem may be brokers' willingness to publish forecasts even when they are blatantly out of date. In this context, post-event consensus forecasts compiled by information providers that mechanically exclude out-of-date estimates provide a considerable value add. The findings also suggest, not unrealistically, that research has the most potential to add value when applied to neglected stocks with no recent broker estimates.

Research Matters

Though passive investing may be in vogue, the study provides tangible evidence of the value that research analysts provide. While forecasting results is just one tiny aspect of investment research, it is both tangible and measurable. That analysts can add value relative to management forecasts is reassuring, and means that analysts may also provide insight on other factors, like competitive position, environmental responsibility, management quality, and risk. In other words, scarce capital can be more efficiently allocated due to the efforts of research analysts.

Diversification - No Free Lunch

If analysts have value to add, why doesn't this translate into better performance?

Some research suggests that it does. For example, small boutique investment firms with high conviction portfolios can generate above average returns.

For research-based investment to flourish, however, three factors that have undermined the active management industry need to be addressed. These are over-diversification, short-term investment horizons, and low risk tolerances.

Until these issues are tackled, the active management industry will remain under pressure.

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