A new study by German academics Rainer Baule and Hannes Wilke from the University of Hagen (Germany) demonstrates that Wall Street analyst analysis of stocks provides information that can be used to increase portfolio profitability.
The objective of the study (published November 28th) titled To Follow or not to Follow – An Analysis of the Profitability of Portfolio Strategies Based on Analyst Consensus EPS Forecasts was to “measure the profitability of investment strategies relying on analyst forecasts.” The authors use two measures of stock undervaluation that relate analyst forecast momentum to the contemporaneous stock returns. With a 35-year window and the highly liquid US stock universe as a sample, the study examines portfolio strategies based on these two measures.
The results show that following trading strategies based on these two Wall Street analyst measures of undervaluation yields annualized Carhart alphas of up to 8.8%. These strategies therefore outperform current pure earnings forecast momentum strategies, indicating that analyst EPS forecast-based relative undervaluation analysis is clearly useful to investors.
Wall Street Analyst Valuations and More on the undervaluation measures
The undervaluation measures used in the study relate the consensus EPS forecast revision to the market valuation change (ie, the stock return). The basic idea is similar to earnings forecast momentum strategies, but the measure does not specifically capture forecast momentum. The measure actually specifies the degree to which a stock is undervalued by the market relative to the analyst valuation, based on both forecast revisions and stock returns.
The measure identifies the part of analyst expectations that have not yet been priced in by the market and that is consequently not yet reflected in the price of the stock. Baule and Wilke suggest that: “If analyst EPS forecasts are informative, trading strategies based on the measure of undervaluation should be profitable and earn significant excess returns after adjusting for well-known risk factors.”
Wall Street analysts EPS forecasts provide useful information to investors
The results of Baule and Wilke’s study show that Wall Street analysts as a group are on average capable of identifying mispriced securities. Moreover, strategies that are based on analysts’ undervaluation measures produce positive Carhart alphas of up to 8.8% per year, significantly greater than strategies based solely on earnings forecast momentum.
The authors conclude: “Our findings suggest that the US stock market is not always informationally efficient and that analyst EPS consensus estimates are informative. Therefore, it might be beneficial to investors to follow sell-side analyst research and to consider the information in analyst consensus EPS forecasts when setting up their portfolio strategy.”