Is stock market research getting better?
Stock analysts were some of the most notorious villains of the late stock bubble. Once it popped, it became clear—in 20/20 hindsight—that many of the sages so prominently featured on CNBC were simply slapping insanely high price targets on profitless stocks, or shilling for their firms’ investment banking business. Instead of money-making geniuses, they turned out to be classic contrarian indicators: Investors should have sold when they said “buy.”
The research settlement New York Attorney General Eliot Spitzer struck with 10 Wall Street firms in late 2002 aimed to improve the quality of analysis at investment banks and the quantity of independent stock research. One provision forced the firms to “sever the links between research and investment banking,” so that analysts would no longer feel pressure to give positive recommendations to investment banking clients. A second provision forced the Wall Street giants to pay $450 million over five years to purchase independent research and provide it to their customers.
Nearly two years later, evidence is trickling out that analysts—especially independent analysts—are earning their salaries and adding value.
Exhibit A: The July 29 Smith Barney Portfolio Strategist (it’s here, but requires registration) updated a study in which it gauged the six-month performance investors would see after following analysts’ advice: buying the stocks with the most positive consensus ratings and selling those with the worst consensus ratings. Since it involves both buying and selling, this strategy factors out the influence of generally rising or falling markets and isolates the implications of following analysts’ advice. Pursuing such a strategy in 2000 would have been disastrous (thanks to all those buys on doomed tech and other stocks). For eight straight quarters—from mid-2001 through mid-2003—investors who heeded the consensus advice would have lost money, including a loss of more than 35 percent in the fourth quarter of 2001. But there were two straight quarters of positive performance in the second half of 2003. True, the returns were small, but they’re an improvement over the poor advice of the past few years.
Exhibit B: A study by three academics, Brett Trueman of the University of California at Los Angeles, Brad Barber of the University of California at Davis, and Reuven Lehavy of the University of Michigan sought a more refined measure of whether stock research adds value. (The paper is posted here.) They examined in minute detail the abnormal daily returns—i.e., returns above and beyond returns of the general market—of stocks recommended by analysts over a seven-year period between February 1996 and June 2003. The trio also distinguished between recommendations issued by independent firms and those issued by firms that conducted investment banking activities.
Over the seven-year period, the buy recommendations issued by independent firms outperformed the recommendations of investment banks by about 8 percentage points annually. (For example, if investment bank recommendations returned 5 percent more than the general market, independent recommendations returned 13 percent more.)
Considering investment banks’ advantages in resources and access to management, the difference is impressive. But the performance of the independent firms since the bust has been even more impressive. Between March 2000 and June 2003, investment bank buy recommendations essentially tracked the broader markets, but independent buy recommendations outperformed the market by about 17 percentage points.
Why would independents do so much better? It turns out that the conflicts that Spitzer set out to eliminate have a lot to do with the underperformance. The researchers did a set of additional tests, and found that the recommendations of investment banking firms made on companies just after equity offerings—initial public offerings or secondary stock offerings—underperformed recommendations of independent firms by 22 percentage points annually. Says Trueman: “That’s consistent with a reluctance on the part of analysts to downgrade stocks that have had investment banking relationships.”
In theory, the settlement—by insulating analysts from the pressure exerted by their investment banking colleagues—should have fixed that. But, Trueman notes, analysts at the 10 investment banking firms that settled with Spitzer weren’t the only ones who placed unwarranted buy ratings on companies that had recently sold stock; all investment banks that conducted both underwriting and research underperformed. In other words, just being in the same company as investment bankers distorted the analysts’ views, and made them excessively optimistic about companies doing stock offerings.
So when your brokerage firm tells you that its analysts’ advice is trustworthy because they’re insulated from pressure, you should smile, nod, and then ask for the independent research.