It’s the earnings season again. Brokerages have started sending their December quarter “earnings preview” to clients. These reports will contain the latest estimate of their in-house analysts, complete with forecasts of quarterly earnings per share down to the last paisa and targets for stock price. Yet, in the current bull run, it’s well known that these targets have often had to be revised within a week of the report being published, the sheer speed of the rally catching even the most optimistic unawares. Of course, that hasn’t prevented analysts from going with the flow, bringing out still more glowing reports or finding “embedded value” in the stock. Rare is the analyst who has swam against the tide.
How impartial are analyst recommendations? In a National Bureau of Economic Research (NBER) paper written last year, titled, Do Security Analysts Speak in Two Tongues?, Ulrike Malmendier of the University of California at Berkeley and Devin Shanthikumar of Harvard Business School set out to study why security analysts issue overly positive recommendations.
To the sceptical layman, there seems to be a straightforward answer—analysts are paid to encourage clients to buy stocks, simply because the universe of potential buyers is always larger than the universe of potential sellers. Malmendier and Shanthikumar, not being so cynical, consider two alternative explanations: One, analysts pick favourite stocks and are genuinely overoptimistic; and two, analysts distort recommendations to maximize commissions and underwriting business, particularly if affiliated with an underwriter.
The researchers found analyst reports had very different impacts on small investors, on the one hand, and large institutional investors, on the other. Small investors were seen to react to simple “buy” or “sell,” often ignoring the subtext in a “hold” recommendation, which may actually be a euphemism for “sell.”
The more sophisticated institutional investors were, however, clearly able to act on such recommendations. That is why, said the researchers, “analysts can speak in two tongues, targeting the more sophisticated investors with the earnings forecasts, and the less sophisticated ones with the recommendations.” The two argue that genuinely overoptimistic analysts will issue both the most optimistic recommendations as well as the most optimistic forecasts. Analysts, however, know that while individual investors will blindly act, institutional investors will be more analytical.
Here’s what Malmendier and Shantikumar conclude: “while affiliated recommendations are significantly more positive than unaffiliated recommendations, affiliated forecasts are significantly more negative than unaffiliated forecasts. Affiliated recommendations are also significantly more likely to be above the consensus than unaffiliated recommendations, while the distribution of affiliated and unaffiliated earnings forecast above and below the consensus is not significantly different. These differences between recommendations and forecasts of affiliated and unaffiliated analysts are consistent with strategic distortion, but not with (mere) overestimation.”
To cut a long story short, researchers found plenty of bias in analysts affiliated with investment bankers. That’s hardly surprising, particularly in the wake of the revelations about how analysts conned their clients during the dot-com boom, knowing fully well their recommendations were worthless.
Perhaps a more charitable explanation is that analysts are merely scrambling to keep up with the market. How many of them were able to forecast the subprime crisis, the dot-com boom or the runaway boom in emerging markets? And even the International Monetary Fund has had to frequently revise its forecasts. Maybe this is what John Maynard Keynes meant when he wrote, “a ‘sound’ banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.”
Another NBER paper by Narasimhan Jegadeesh and Woojin Kim, titled Do Analysts Herd? An Analysis of Recommendations and Market Reactions, says that recommendation revisions are “partly driven by analysts’ desire to herd with the crowd.” They found stronger herding instincts for downgrade, which suggests analysts are more reluctant to stand out when they convey negative information.
Not all studies are negative. Jason L. Hall and Paul B. Tacon of the University of Queensland Business School say, “The accuracy of analysts’ earnings forecasts has been studied extensively, across multiple, international jurisdictions. Analysts possess differential ability to forecast company earnings, and this effect persists over time. Also, empirical evidence suggests that analysts possess differential ability to forecast target prices.”
So, should we consider which analysts have the best track records and follow their recommendations? Alas, it’s not that easy. The researchers find “Comparing analysts ranked in the top third on forecast accuracy in a prior period to those ranked in the bottom third, the accurate analysts have only 5% lower forecast error than inaccurate analysts in a subsequent year.”
And in these euphoric times, investors would do well to remember this conclusion: “There is evidence of a pre-disposition amongst all analysts to recommend glamour stocks with positive price momentum.”
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org