Are Rankings Of Financial Analysts Useful To Investors?
Universidade do Porto – Faculdade de Economia (FEP)
Universidade do Porto – Faculdade de Economia (FEP)
Carlos Soares
Faculty of Engineering
October 26, 2015
Abstract:
Several institutions issue rankings based on the accuracy of price and EPS forecasts. Given that these rankings are ex-post they may not be able useful to investors. In this paper we show that trading strategies based on perfect foresight and past rankings outperform a passive strategy. In addition, we report that investors are better off following analysts that issue accurate price targets rather that those with accurate EPS forecasts.
Are Rankings Of Financial Analysts Useful To Investors? – Introduction
The idea that financial analysts play an important role in financial markets is rather consensual (Cowles, 1933; O’Brien, 1990). Yet there is some debate on whether following the advice of analysts brings value to investors after transaction costs (Womack, 1996; Mikhail, Walther, and Willis, 2004; Li, 2005). Related to this is the difficulty in identifying the analysts with superior stock picking skills. In this paper, we show that the rankings of financial analysts are useful to investors because strategies based upon these rankings yield positive abnormal returns.
In recent years, some institutions have been very active in publishing and selling rankings of financial analysts. Some rankings are based on privately held surveys of buy-side analysts (e.g., the Institutional Investor’s rankings of the All-America Research Teams1 and Bloomberg’s America’s Best Stock Analysts2); others are based on the performance of sell-side analysts (ThomsonReuters’ top StarMine analysts3). In any of these cases, the rankings aim at identifying the top analysts. However, aside from personal acknowledgment among peers, it is still arguable whether these are useful to investors (Desai, Liang, and Singh, 2000) or are merely “popularity contests” (Emery and Li, 2009).
We show that the top ranked analysts have stock picking skills. The contributions of our research is fourfold. First, we develop a trading strategy that transforms the rankings of financial analysts into inputs for the Black-Litterman model (Black and Litterman, 1992). Second, we show that annualized cumulative returns generated by some trading strategies based upon analysts’ rankings outperform a passive strategy (e.g., buy-and-hold the general stock market index). Third, we show that the strategy based upon the perfect foresight of rankings yields the highest cumulative annualized return. Fourth, we find that investors are better off following analysts that issue the most accurate target prices, rather than those that issue the most accurate EPS forecasts.
The paper is organized as follows: section 2 provides motivation to use rankings of financial analysts; section 3 outlines our proposed trading strategies; section 4 describes the sample and presents some preliminary results; section 5 presents and discusses the results; and section 6 concludes.
Industry Rankings of Financial Analysts
In the financial literature there has been a long debate on whether financial analysts produce valuable advice. Some argue that following the advice of financial analysts, translated as recommendations of buying, holding, or selling a particular stock, does not yield abnormal returns, i.e., returns that are above the required return to compensate for risk. The Efficient Market Hypothesis (Fama, 1970) states that financial markets are efficient and that any public available information regarding a stock would be immediately reflected in prices; hence, it would be impossible to generate abnormal returns based upon past information.
Yet, several authors have since stressed that there are information-gathering costs and information is not immediately reflected on prices (Grossman and Stiglitz, 1980). As such, prices may not reflect all the available information at all time because if this were the case, those who spent resources to collect and analyze information would not have an incentive to do it, because there would not get any compensation for it.
Some authors show that financial analysts’ recommendations create value to investors (Womack, 1996; Barber, Lehavy, McNichols, and Trueman, 2001)4. Assuming that some analysts produce valuable advice it makes sense to rank analysts based on the accuracy of their recommendations.
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