The Value of Fundie Analysts?

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

Yesterday, we discussed that some analysts at major firms have been "tweaking" and "correcting" their prior ratings and up/downgrade 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 phenomena, or has it been successful in years prior? 

So while we ponder what this brewing ethical quamire 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. 


Note: This post adds the category "Quantitative"


Skeleton at the Feast
Barron’s Monday, January 8, 2007

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  1. Leisa commented on Mar 6

    Given the extreme goofiness of seeing analysts state the obvious (read, putting in outperform ratings on stocks that just blew out their numbers or the obverse, putting sell or hold ratings on stocks suffering “whackage”), I’ve never taken any of these analyst ratings into consideration. (And let’s not forget the controversial analyst call for NEW being trumped about)unless it is to bet against them. The money moves in for buys and out for sells so quickly, for the quick it can be a profitable flip.

  2. Trent commented on Mar 6

    Fama would probably argue that the best-covered names are more efficiently priced, and that there is an unidentified risk factor in the least-covered names that justifies the higher return.

    I buy the first part of that argument, which is that more coverage = more efficient pricing, and don’t doubt that there are better opportunities down the road less traveled. In fact, it is the strongest counter-argument to the EMH – that without analysts there wouldn’t be the efficiency that supposedly renders them valueless.

  3. alon commented on Mar 7

    I dont think its a coincidence that the ‘less followed’ performance is very close to the russell 2000 value. The smaller low growth stocks will always be less followed as they are not well known to public, not highly traded, and exclude ‘sexy’ or quick growth potential sectors like tech and biotech. I suspect the less followed stocks will often represent the small value performance.
    p.s. i gave up on fundamental research years ago and this is not a defense for analysts. Thanks!

  4. Dirk van Dijk commented on Mar 7

    I actually worked at I/B/E/S many moons ago (durring the 1980’s) and did most of the in house research on the database and worked with academics who used the data. While it is news that the “neglected stock effect” was the best preforming startegy in 2006, the fact that it is an anomoly in the EMH is not. Good academic research on the topic dates back to the early to mid 1980’s. In particular I would cite Arbel and Strebel’s “Pay Attention to Neglected Firms! Published in the Journal of Portfolio Management(JPM), Winter 1983, Arbel’s “Generic Stocks: An Old Product in a new Package” JPM Summer 1985 and Arbel and Strebels “The Neglected and Small Firm Effects” Financial Review Vol 17. No 4, 1982. In short thing of analyst coverage as being sort of like an advertising budget for a consumer product. Buying a brand name of canned peas gives you some more information (at least perceived) about the quality of the product, but it will cost you more (have a lower return) than buying the black and white generic can of peas. As for the brewing scandal, I suspect the fault is more with the Brokerage firms, than with I/B/E/S, although one could argue that I/B/E/S should have caught it. If I/B/E/S was aware of it and went along, that is a huge scandal, on par with what was going on in the old Jack Grubman/Henry Blodget days on Wall St. At Zacks we are currently reviewing our database to make sure we didnt inadvertantly do the same thing. I know we have not done so intentionally, but Zacks and I/B/E/S are both to a large extent dependent on the data provided to us by the brokerage firms. There are some controls in place, but they are not perfect. If we did we will correct it. As things stand now I think we have the origional recomendations in our historical tape, but we are checking on it to make sure.

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