Bucks Not a Matter of Luck

It’s a perennial debate among investors and financial professionals: Should greater market returns be attributed to superior stock-picking acumen or to mere luck?

Research by Kellogg School Associate Professor of Accounting Beverly Walther and two co-authors considers the question with respect to sell-side analysts — professionals employed by brokerage houses to manage accounts and create publicly available research often relied upon by investors.

“We examined whether certain analysts were better than others,” says Walther, who, along with Michael B. Mikhail of the W. P. Carey School of Business and Richard H. Willis of the Owen Graduate School of Management, published “Do security analysts exhibit persistent differences in stock picking ability?” in the Journal of Financial Economics in 2004.

“Can you earn greater returns following their advice?” asks Walther. “If I focus on a small number of analysts, can I assume that some have greater skills and some have more luck? It’s documented that there are differences, but are there persistent differences?”

Yes, indicates the research. Says Walther: “Some are more skilled in giving good advice. We found there is persistence in the profitability of their stock recommendations; the ones who performed well in the past continued to do so and vice versa.”

Recently, sell-side analysts have reacted to criticisms, including charges that research picks are little more than a way to generate business for the firms that employ them, and that their recommendations are heavily influenced by investment-banking business their employers hope to capture. Some financial columnists advise investors to read analysts’ reports and take the opposite position — buy when they say sell and sell when they say buy. Others contend that legislative reforms will soon put sell-side analysts out of jobs.

Whatever the future may hold for these analysts, Walther’s research makes one thing clear: Some are better at their jobs than others.

In their study, Walther and co-authors looked at recommendations issued by 4,923 analysts from 1985 to 1999, examining their results at one-, three- and five-year intervals. The authors conclude that “analysts who have issued more (less) profitable recommendations in the past tend to issue more (less) profitable recommendations in the future, which is consistent with relative persistence in stock picking ability.”

Moreover, differences between the skilled and unskilled group became greater with time, increasing at both the three- and five-year intervals and lending some credence to ranking surveys such as those compiled by The Wall Street Journal.

Walther and her co-authors build upon previous research that suggests while investors might do well to look to past performance when selecting a pension plan, there is no systematic evidence of persistence in the performance of mutual funds. But the three note that buy-side results might not extend to the sell-side, given “institutional differences between the two groups,” including performance goals and compensation, and tighter buy-side regulation.

But the question remains: Will investors accrue large financial gains by heeding market cues provided by the best performing sell-side analysts? Walther found the market tends to react more strongly to the recommendations of top performers than those of poor performers. When she and her colleagues analyzed a trading strategy that allowed three days to implement top-performing analysts’ recommendations, they found investors would not earn excess returns after adjusting for risk and trading fees. The margin became slightly better if investors were able to react immediately to the new information. Holding periods examined were three, 20 and 60 trading days.

Walther notes, though, that for those planning on making an investment anyway, it does make sense to pay attention to cues from top-performing analysts. The amount of information available to investors has exploded over the years, she says, helping “individuals narrow down the field of who to pay attention to.”

Since documenting these differences in stock-picking ability, the researchers, along with Xin Wang of the Fuqua School of Business, have turned their attention to uncovering the reasons why.

Preliminary results show that better-performing analysts tend to have more resources (many worked at larger brokerage firms), issue their reports in a more timely fashion and concentrate their efforts more in a given industry.

Initial findings also suggest that the best sell-side analysts are more adept at using publicly available accounting information to predict a company’s future. “It isn’t just that you have better resources. It’s that you are better able to take publicly available information and analyze it,” Walther says.