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Analyst Picks Fail To Beat S&P 500

By Sophie Brodie

Analyst recommendations have yielded lower returns over the past decade and proved riskier than index funds tracking the S&P 500, according to a study by Randall Woolridge, a finance professor at Pennsylvania State University.The study's purpose was to establish how investors would have fared if they had followed brokers' advice from 1993 to 2002. Although investment banks and brokerages have done well out of the stock market over the last half century, investors have often questioned brokers' ability to pick winning stocks. This year, in the wake of the US regulators' $ 1.4bn (£1.2bn) settlement with 10 banks that issued misleading research, investors have moved from worrying whether an analyst's advice was accurate to wondering whether it was honestly given.

Woolridge suggests that recommendations be treated with caution as analysts are prone to over-sell their ideas. Top-tier players are tainted by investment banking scandals while mid-tier banks promote less well known companies that are more likely to be mispriced.

He says: "These analysts are all very bright people who can communicate well and deliver. But should we listen to them when, as a group, they fail to beat the market? Investors must do their homework as brokers are often swinging for the fences."

Using data from Zacks Investment Research, the study found that stock recommendations of 15 top and mid-tier brokers in the US achieved an average quarterly and cumulative return of 2.17%, while the S&P 500 returned 2.26%.

Only 10 of the 15 brokerages provided data for the entire period studied. On a risk-adjusted basis, just three of the 10 outperformed the S&P 500, Bear Stearns, Merrill Lynch and Raymond James. Top-tier banks within the 15 together posted an average quarterly return of just 1.99%.

Overall, top-tier brokerages performed less well than mid-tier regional firms and also tended to publish higher-risk recommendations. Of the top-tier firms, Merrill Lynch was the frontrunner. The US bank achieve an average quarterly return of 3.07%, but it also issued the recommendations with the lowest risk factor. Lehman Brothers came last in the top-tier section with an average return of 1%.

Lehman also produced the highest standard deviation of 13.23%, while Morgan Stanley had the lowest at 8.45%. Standard deviation for the S&P 500 was 8.49% while the average for top-tier firms was 10.6%. Raymond James produced the best results among the mid-tier regional banks with returns of 3.33%.

Woolridge says: "The big surprise is that the results for individual firms vary a great deal."

However, other research studies have found analyst recommendations have value at the point of issue.

On the day that analysts upgrade a stock from a Hold to a Buy, trading doubles and prices rise around 3% on a risk-adjusted basis on the stock. When stocks are downgraded recorded volumes are larger and prices decrease even more.

Stock prices react most when analysts initiate coverage of stock with a Buy recommendation, particularly on the opening trade.

This had led the researchers to conclude that the value of such a recommendation benefits the clients of the analysts' brokerage firm.

A study in 1999 which evaluated Buy recommendations by underwriting analysts against those issued by independent analysts found that, over six months, returns from stocks recommended by unaffiliated analysts were more than double those from analysts within investment banks.

Woolridge says: "If you look at the results of the study overall and adjust for risk, there is a 1% risk return relative to the S&P index. In that case, investors are better off buying a tracker fund with a fee of only 25 basis points."

Copyright 2003 eFinancialNews Ltd.

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Penn State's Smeal College of Business offers highly ranked undergraduate, MBA, executive MBA, Ph.D., and executive education opportunities to more than 5,500 students at all levels. Featuring academic departments of accounting, finance, marketing, insurance and real estate, management, and supply chain and information systems, the college is also home to major research centers such as the Center for Supply Chain Research, the Institute for the Study of Business Markets, the eBusiness Research Center, the Farrell Center for Corporate Innovation and Entrepreneurship, the Center for Global Business Studies, and the Center for the Management of Technological and Organizational Change.

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