Reassessing the Returns to Analysts' Stock Recommendations

After a string of years in which security analysts' top stock picks significantly outperformed their pans, the years 2000 and 2001 were disasters. During those two years, the stocks least favored by analysts earned an average annualized market-adjusted return of 13.44 percent whereas the stocks most highly recommended underperformed the market by 7.06 percent, a return difference of more than 20 percentage points. This pattern prevailed during most months of 2000 and 2001 and was observed for both technology and nontechnology stocks. Additional analysis suggests that these poor results were driven, at least in part, by analysts' tendency to recommend small-capitalization growth stocks during those years, despite the fall of those stocks from favor. Whether or not this preference was motivated by a desire to attract and retain the most lucrative investment banking clients, our findings should add to the debate over the usefulness of analyst stock recommendations. They should also serve to alert researchers to the possibility that excluding 2000 and 2001 from their sample periods could have a significant impact on any conclusions they draw about analyst stock recommendations. Investors have been growing increasingly suspicious of the value of sell-side analysts' stock recommendations in recent years. With investment banking business booming during the late 1990s and early 2000, the belief spread that analysts were focused on attracting and retaining investment banking clients rather than on writing research reports that accurately reflected their opinions of the companies they followed. “Sell” recommendations became scarcer, and “buy” recommendations became less meaningful to investors. The goal of the study we report was to analyze the returns to analysts' recommendations during the 1996–2001 period to discern the extent to which the recommendations continue to have value. The research followed the approach of a similar analysis we conducted for the 1986–96 period, a time during which the impact of investment banking on analysts' research reports was, arguably, of less concern. For this period, we found sell-side analysts' stock recommendations to have significant value: The stocks with more favorable consensus (average) recommendations outperformed the less favored recommendations. A portfolio of the most highly recommended stocks generated an average annual market-adjusted return of 3.97 percent, whereas a portfolio of the least favored stocks yielded an average annual market-adjusted return of –9.06 percent. For the years 1996–1999 covered in the study reported here, we found market-adjusted returns that are similar to those for the earlier period. The returns for the years 2000–2001, however, are strikingly different. The market-adjusted return on the most favorably rated stocks in 2000 and again in 2001 was about –7 percent, whereas the market-adjusted return on the least favored stocks in 2000 was a quite large 17.6 percent and in 2001, 9.3 percent. The difference between the returns to the most highly rated and least favored stocks, almost –25 percentage points in 2000 and about –16 percentage points in 2001, reflects years of very poor performance of analyst recommendations. In additional analyses, we found that these poor results were in evidence for most months of 2000 and 2001 and that they were more pronounced for technology companies (the strongest segment of the market leading into 2000) than for nontechnology companies. Perhaps most surprising was the finding that the least favored tech stocks actually rose in 2000–2001, at a time when the sector as a whole was suffering sharp declines. Key to understanding these results is the additional finding that during both the 1996–99 and 2000–01 periods, the most highly recommended stocks were generally small-capitalization stocks with low book-to-market ratios (so-called growth stocks), while the least favored stocks, although also small-caps, had high book-to-market ratios (so-called value stocks). This fact is noteworthy because in the 1996–99 period, small-cap growth stocks vastly outperformed small-cap value stocks, but during 2000–2001, value stocks trounced growth stocks. Analysts' continued tendency to recommend the (now out-of-favor) small-cap growth segment in 2000 and 2001 apparently led to their picks underperforming their pans in this period. Even with the very poor analyst performance in 2000–2001, the most highly recommended stocks during the 16-year period from 1986 through 2001 period still generated significantly greater average annual market-adjusted returns than did the least favored stocks. This result reflects favorably on the long-term value of analyst recommendations, as long as the 2000–01 results are an extreme aberration that is unlikely to be repeated. If this recent performance reflects an inability or reluctance on the part of analysts to adapt to changing market conditions (such as might be the case if analysts continued to favor small growth firms over small value firms because of their potentially greater investment banking business), however, then analyst performance for the whole period will not be a reliable predictor of future returns to analyst picks. At any rate, our results should alert researchers to the possibility that excluding the years 2000–2001 from their sample periods could have a significant impact on any conclusions they draw regarding analyst stock recommendations.