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Value in contrary analyst ratings: Pessimism paid off, study says

By Lynn Cowan
Dow Jones Newswires

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WASHINGTON — While there was money to be made off analysts' recommendations during the bull market's rise and fall, investors would have had a better chance if they had some inside information on the analyst's employer.

A new study shows that from 1996 to 2003, the best analyst stock recommendations were those that went against the grain of the securities firms issuing them.

If the analyst's call was contrary to the overall bearish or bullish stance of the firm, investors had a greater chance of making money on that advice, the study found. It was conducted by business-school professors Brad Barber of the University of California, Davis; Reuven Lehavy of the University of Michigan; Maureen McNichols at Stanford University; and Brett Trueman of UCLA.

The study divided Wall Street into different camps based on the proportion of "buy" or "sell" ratings that research departments maintained on stocks they covered, classifying them as "optimistic" or "pessimistic" firms.

They found that stock upgrades to the "buy" level issued by analysts at firms with the smallest percentage of "buy" recommendations significantly outperformed those of brokers with the greatest percentage of "buys," by an average of 0.5 percentage points per month.

On the flip side, downgrades to "hold" or "sell" coming from brokerages with the most "buy" recommendations outperformed those of brokers issuing the fewest, by an average of 0.46 percentage points per month.

"We were trying to answer whether knowing those distributions could have been valuable for investors," said Lehavy.

Indeed, they found that knowing whether a firm's overall proportion of "buys" to "sells" tended toward the optimistic or pessimistic side would have given investors a useful tool to winnowing out profitable stock recommendations, particularly from January 1996 until September 2002.

But that information wasn't available on a firm-by-firm basis until Sept. 9, 2002, when new regulations required firms to disclose their ratings distributions on every research report.

Naturally, once the new regulations took effect, the differences between various brokerage firms' buy-sell distributions narrowed. There was no longer an advantage to be had in trying to follow recommendations from analysts that are contrary to their firms' bent, according to Lehavy.
 
The authors' paper on the study said the new rules curbed some firms' tendencies toward issuing overly optimistic research.

The study analyzed 438,000 stock recommendations issued on more than 12,000 companies by 463 investment banks and brokerage firms between January 1996 and June 2003. The authors then tracked all the stock upgrades and downgrades issued by the 463 banks and assumed on each recommendation they would either buy the stock or sell it short, investing $1 in each strategy.

The authors used data from ratings tracker Thomson First Call, which required them to sign a confidentiality clause prohibiting them from publicly naming which Wall Street firms were the optimists and which were the pessimists.

However, the authors did compare the 10 investment banks that had taken part in the global settlement over tainted research and found there was only a small difference — about 1.7 percent — between their percentage of "buy" recommendations and that of their nonsanctioned peers.