analyst ratings

Analyst Ratings: Buyer Beware

Here’s a smarter way to look at Buy/Sell/Hold analyst ratings.

Prepare to have your mind blown! Okay, I am being facetious. In a recent study, Factset proved that analyst ratings and recommendations have NOT been a good predictor of stock market performance. You can see the Michael Amenta findings here.

The Research Analysts on Wall Street have been very biased towards buy recommendations, and the consequence is that consumers of their recommendations need to use extreme care when looking at them. Currently there are zero—that’s right, zero—sell recommendations on stocks within the S&P 500. So, there isn’t a single stock within the S&P 500 where the analyst ratings consensus is to get rid of the stock. It almost seems like the fix is in—why would there be so few sell recommendations?

I can only think of two reasons. This first is less cynical. Analysts that issue a sell recommendation better be right! They are going to stand out in a crowd, and really need to defend this rating from their institutional clients that hold this stock. So, given that it will cause a little upheaval with their client base, they are not going to issue the dreaded sell recommendation unless they have conclusive proof. Contrast this to a buy recommendation, which makes their clients happy, and fits in with the crowd.

The second reason is more nefarious, and wrapped up in the inherent conflict of interest of the large sell side investment banks. You have two departments: one the Investment Banking department that is scouring corporations for business. They want to work on their Mergers and Acquisitions, float their debt, or be there when they do an IPO. They desperately don’t want their brethren in the Research Department issuing a sell recommendation that might ruin their chances of winning business.

Regardless of the reason, Analysts tend to be slanted toward buy recommendations. The upshot of this phenomenon is that these recommendations completely fail as good predictors of performance. In Factset’s 10-year study, they found that stocks that rated as “holds” (i.e. neutral) performed the best, and yes, outperforming the stocks rated as “buys.”

The Value of Analyst Ratings

So is there value to these ratings? At all? The answer is twofold. One, the movement of analyst ratings is critical. Marc Chaikin of Chaikin Analytics, which has a 20-factor model of stock performance called the Chaikin Power Gauge rating, said that he had observed this problem when he created the model. Rather than discard analyst ratings altogether, he used the change in rating rather than the absolute rating. For example,  a stock that moves from a “buy” to a “hold” is a negative indicator. He then studied the appropriate time frames, and rigorously back-tested before incorporating this factor into his model. Any change of analyst rating became a very predictive indicator.

The other method is to look at the 2-5% of all equities that are rated as a “sell” or “underform” and get rid of them. Over time, Factset found that they do tend to underperform. This is not surprising, as the sheer bravery of an analyst putting a negative rating on a stock is so onerous that the analyst usually is pretty sure that the stock in question is a real dog.