Should Investors Rely on  Analyst Recommendations?

By Arie Goren

Usually, investors who manage their own investments by picking stocks will look to see what capital market analysts recommend. This is partially because many investors believe that professional analysts have greater market expertise and specific knowledge about the companies they follow.

However, will following analysts’ recommendations provide the desired return? Can an investor beat the market by creating a portfolio according to analysts’ recommendations? In order to answer this dilemma we have conducted research based on fifteen years-back testing that compare the performance of stocks according to the average analysts’ recommendations.

Investors can access analysts’ opinions through TipRanks, and many other financial websites. In general, the custom is to divide recommendations into five ranks.  In order to calculate the mean recommendation, each rank is given a number, as shown in the table below.

 Analyst Recommendations
Analyst Recommendations

For example, a stock that has one Strong Buy recommendation, one Buy and one Hold, will receive 2.00 as its mean rate, and a stock with two Strong Buys and one Buy will get 1.33 as its mean rate.

 

Back-Testing Past  Analyst Recommendations

To back-test past recommendations, we used the Portfolio123?s historical database of analysts’ recommendations, and its back-testing capability to perform the comparison between the two following groups of stocks:

  • Group A – The best 100 S&P 500 stocks, according to their analysts’ mean recommendation.
  • Group B – The worst 100 S&P 500 stocks, according to their analysts’ mean recommendation.

We then ran back tests of these two groups in order to see how they performed during the last year, the last 5 years and the last 15 years. The back-test is based on selecting the 100 stocks of each group that meet the requirement (100 best or 100 worst recommended) every four weeks and replacing the stocks that no longer comply with the requirement with stocks that meet the requirement. In other words, every four weeks the stocks in each group changes according to their performance. The theoretical return is calculated in comparison to the benchmark (S&P 500), considering 0.25% slippage for each trade and 1.5% annual carry cost (broker cost). The back-tests’ results are shown in the tables below.

The table below shows the analysts’ compound average annual return for the two groups and for the S&P 500 index

 Analyst Recommendations
Analyst Recommendations

The results do not show a significant difference between the two groups. However, the 15 years return of the worst recommended group of 100 S&P 500 stocks has had a better return at 9.51% than that of the best recommended group, which stands at 6.46%. Both groups have had better return than that of the S&P 500 index.

The table below shows the maximum drawdown of the two groups and for the S&P 500 index

Analyst Recommendations
Analyst Recommendations

Also at this parameter, the results do not show a significant difference between the two groups. However, during the last 15-years, the worst recommended group of 100 S&P 500 stocks has had a maximum drawdown of 69.96% higher than that of the best recommended group of 54.00% and the S&P 500 index of 57.00%.

The clear conclusion that we can draw from this research is that following analysts’ mean recommendation would not provide investors any advantage.

 

Ranking  Analyst Recommendations performance

So, where can investors find help for their stock picking? The answer is, they should separate the wheat from the chaff. In other words, to follow recommendations only from analysts that have proven very positive accuracy of their previous calls. TipRanks is a website that ranks experts (analysts and bloggers) according to their performance. For example, the current first ranked analyst by TipRanks David Bianco of Deutsche Bank has had 92 out of 102 successful ratings which indicates a 90% success rate with an average one year return per recommendation of 18.1%. Furthermore, investors can also use bloggers’ recommendations. According to TipRanks, top bloggers have shown amazing consistency in their recommendation results. For example, the first ranked blogger by TipRanks “Dividend Growth Investor” has had 403 out of 500 successful ratings which indicate 81% success rate with an average one year return per recommendation of 12.1%.

The conclusion that we can draw from the discussion above is that investors can get much help in their stock picking. However, they should not follow the average analysts’ opinion, but only use recommendations from top analysts and bloggers that have proven consistency and excellent success rates in their previous calls.