Background and Research
Analysts issue recommendations on securities and make earnings estimates which are used to estimate securities values. Customers of full service Brokers usually have access to the firms' analysts and their research. Zacks, First Call, Profound, and Value Line are some of the commercial services offering investors information based on analysts earnings estimates.
Brokerage firms spend hundreds of millions of dollars annually analyzing stocks and analysts' recommendations are closely watched by many. However, research has cast doubt on whether investors can benefit from following their advice. The vast majority of analysts reports are positive and issuing sell signals is generally considered riskier for an analyst's reputation. Additionally, many analysts may be reluctant to issue negative reports fearing that companies may limit their access to the company and because it may have a negative impact on present and/or prospective investment banking relationships.
It's important to keep in mind that a primary function for most analysts is to support their firm's investment banking operations. When investment banking firms price IPO's and other securities, the firm's analyst(s) normally plays a major role and respected analysts can significantly impact firms' decisions about which investment banker(s) to use in selling their securities. In his classic book The Intelligent Investor, Ben Graham wrote "Investment banking is perhaps the most respectable department of the Wall Street community because it is here that finance plays its constructive role of supplying new capital for the expansion of industry."
Further complicating the issue of how to interpret analysts estimates is the recent emergence of "whisper" earnings. The Wall Street Journal ran an article on January 16, 1997 about Intel's earnings report after the close two days earlier. Intel reported earnings of $2.13 per share for the 4th quarter far exceeding consensus estimates in the $1.84 range. The stock proceeded to drop 5.125 to $142 the following day. According to the article, the reason for the drop was investors expectation that the number would be much higher than analysts published estimates. The article asks whether small investors are out of the "loop" because many analysts may publish one estimate but actually believe (and infer to clients) companies will earn more or less (their "whisper" estimate).
There have been many web sites in recent years that publish whisper numbers (EarningsWhispers.com, WhisperNumber.com, and The WhisperNumber.com among others). While their forecasts can vary and the operators of these sites might use different methods in arriving at their estimates, there were some credible studies that concluded that the whisper numbers tended to be more accurate than the consensus earnings. The common occurrence of stocks falling after announcing earnings that meet or beat consensus earnings (yet coming up short of whisper number) implies that in many cases traders place more emphasis on whisper numbers.
At the Social Science Research Network you can read an academic paper by Mark E. Bagnoli, Messod D. Beneish, and Susan G. Watts titled Whispers and Shouts: Forecasts of Quarterly Earnings Per Share. The Professors compared First Call analyst estimates from 1/95 to 5/97 to roughly 1,000 whisper forecasts and found that on average the whisper forecasts were more accurate. Analysts tended to be too pessimistic, while the whispers tended to be too optimistic.
The following are some other studies and articles about analysts and their work.
- David Dreman, "Missing the barn door," Forbes (10/21/1996)
With Eric Lufkin, Dreman studied 78,695 analysts' consensus forecasts from 1973 to 1993. The odds are staggering against the investor who relies on fine-tuned earnings estimates. They estimate there is only a 1 in 170 chance that the analysts' consensus forecast will be within 5% for any 4 consecutive quarters. Dreman's follow-up article titled "Fallible forecasts" appeared in Forbes on 12/29/97.
- David Dreman and Michael A. Berry, "Analyst Forecasting Errors and Their Implications for Security Analysis," Financial Analysts Journal, May-June 1995.
Dreman and Berry reviewed earlier research and studied 66,100 consensus estimates of Wall Street analysts from 1974 to 1991. There findings included the following.
- "We demonstrate that consensus forecasts, revised as recently as two weeks prior to the end of the quarter for which the earnings forecasts were made, deviate significantly and consistently from actual earnings."
- "Standardized errors are large uniformly across industries, indicating that even on a volatility-adjusted basis, analysts err indiscriminately across industries."
- "...on average, large earnings surprises are the rule rather than the exception."
- "A final conclusion of this study is that in spite of our earlier findings, analysts, money managers, and investors appear to ignore the industry's poor forecasting record, although it questions the viability of many important stock valuation methods."
- Roni Michaely and Kent L. Womack, "Conflict of Interest and the Credibility of Underwriters Analysts' Recommendations," preliminary paper Sunriver Oregon, June 19-22, 1996. The paper won the 1996 AAII outstanding paper award. The paper examines how possible conflicts of interest within an investment banking firm may affect analyst recommendations of IPOs. They found that recommendations from analysts of companies that the analyst's firm had underwritten substantially trailed the market average by 13.9% for two years from the time of the IPO. In contrast, recommendations of IPOs made by analysts that were not with the underwriting firm outperformed the market by 32.1% over the same time period. See also Investors Beware.
Some other studies that have been supportive of analysts.
- Lawrence D. Brown, "Analyst Forecasting Errors and Their Implications for Security Analysis: An Alternative Perspective," Financial Analyst Journal, January-February 1996. Brown argued contrary to the conclusions of Dreman and Berry (see above) that (1) analysts forecasts are not "too large", (2) analysts' earnings forecasts are more accurate than naive models, (3) errors have not been increasing with time, (4) in the period following the study by Dreman and Berry, analysts have been too pessimistic (not optimistic), (5) and that the investment community places too little reliance on analysts' earnings forecasts.
- Kent L. Womack, "Do Brokerage Analysts' Recommendations Have Investment Value?" The Journal of Finance, March 1996.
Womack documented earlier work that found little or no evidence that analysts recommendations produce abnormal returns. Using data from 1989 to 1991, and based upon a number of assumptions, he analyzed analysts recommendations (changes from extreme ratings - analysts use a variety of ranking systems) and found that the initial reaction (three days) is a 3% rise for buy recommendations and a 4.7% drop for sells. He also found incremental positive returns of 2.4% for the month following buys and a -9.1% drift over the six months following a sell (initial gains were "not mean-reverting").
Ranking the analysts
Analysts are ranked annually by Institutional Investor (II) magazine and The Wall Street Journal (WSJ). II ranks the analysts by surveying directors and CIOs of major money management institutions, key investors, analysts at top institutions and portfolio managers. The analysts are ranked for picking stocks, writing reports, estimating earnings, acquiring knowledge of the industry, being responsive to clients' requests, and initiating timely calls to investors. Equity rankings from Institutional Investor are here. WSJ ranks analysts less subjectively on an annual basis for both stock picking and earnings estimate prediction accuracy. II has published annual rankings since 1972, while the WSJ has now been ranking analysts about a decade. A high ranking by II can be worth hundreds of thousands of dollars in compensation for analysts. Here are the Wall Street Journal ($$) 1998 and 1997 surveys.
"Security analysts have enormous difficulty in performing their basic function of forecasting earnings prospects for the companies they follow. . . . Bluntly stated, the careful estimates of security analysts (based on industry studies, plant visits, etc.) do very little better than those that would be obtained by simple extrapolation of past trends. . . "
Burton Malkiel in "A Random Walk Down Wall Street" (5th edition) "When even the analysts are bored, it's time to start buying."
Peter Lynch (Peter Principle #9) "Beating the Street "
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