Can the “Experts” Help You Beat the Market?

Should investors follow the recommendations of experts in picking stocks? Consider the findings in a April 2001 paper entitled “Can Investors Profit from the Prophets? Security Analyst Recommendations and Stock Returns” by Brad Barber, Reuven Lehavy, Maureen McNichols and Brett Trueman. Using the Zacks database for the period 1986 through 1996, they conclude that:

• A portfolio of the stocks with the most (least) favorable consensus analyst recommendations provides an average annual excess gross return of +4.13% (-4.91%) percent.
• The difference between the returns of the highest rated and lowest rated stocks are greatest for small and medium-sized firms, for which public information is less widely disseminated.
• The return decreases if the portfolio is not rebalanced daily, or if there is a delay in acting on changes in consensus analysts recommendations. The consequent intensive trading generates such high transactions costs that none of tested strategies yields an excess net return reliably greater than zero.

The authors note that analyst recommendations may still be valuable for investors who are otherwise considering buying or selling.

A more recent paper, “The Value of Client Access to Analyst Recommendations” by Clifton Green from February 2004 finds that clients of analysts appear to attenuate returns to other investors by front-running the public release of analyst recommendations.

In summary, portfolios built using aggregate analyst recommendations may produce gross outperformance, but transaction costs absorb excess returns. Moreover, privileged investors get the jump on analyst-driven trades.

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