Tuesday, July 21, 2015

Analyst Ratings: When It Pays To Do The Opposite

According to this Barron's article, the highest rated stocks by Wall Street analysts between 2002-2014 collectively returned 9.5%.

So the highest rated stocks collectively did more than just fine. The funny thing is that the stocks liked least by the analysts -- those with the lowest ratings -- collectively performed even better.

In fact, the lowest rated stocks produced a 13.2% average annual return.*

Now, this outperformance by the most hated stocks apparently doesn't just apply to the 2002-2014 time period.

Back in 2006, Barron's published an article on a study that covered from 1995-2004 that noted a similar outcome:

"From 1995 through 2004, the stocks with the lowest earnings-growth forecasts and worst ratings beat those with the highest."

In the same article Charles Schwab's Greg Forsythe notes:

"You are better off doing the opposite..."

So we've got a solid couple of decades to look at here and, well, going with the opposite -- the lowest rated -- would have produced better results.

A scene from an episode of Seinfeld comes to mind. The title of that episode just happens to be "The Opposite":**

"If every instinct you have is wrong, then the opposite would have to be right." - Jerry Seinfeld speaking to George Costanza in "The Opposite"

Now, at least to me, it seems rather impractical to be attempting to buy and sell so many different stocks -- whether going with ALL the highest-rated or ALL the lowest-rated -- at just the right price/time in order to match these returns. Those who trade more frequently, or possibly some fund with enough scale, may be more comfortable with such an approach.

Also, the impact of frictional costs and mistakes on future returns must be considered. Observing what already happened in hindsight is very different than attempting to make sound investment decisions going forward, in an uncertain world, based upon the recommendations of others. Mr. Market usually throws a curve or two. Temperament, emotions, and biases become all-important factors that, in real-time, tend to have an effect on investor behavior and decision-making.

I happen to think making investment decisions based upon what others recommend is difficult at best if not inherently flawed.

The reason?

If nothing else, the necessary conviction likely won't be there when market price action happens to go the wrong way.

Lacking the necessary -- and, equally important, warranted -- conviction is just asking for inopportune buy/sell decisions.

Understanding the reason why you own something is essential. To me, that comes from doing the necessary work yourself and reaching your own conclusions. Each business comes with a unique set of risks and opportunities. Without some depth of understanding, the inevitable market fluctuations can become tough to handle. In other words, it's difficult to hang in there when a stock meaningfully drops in price if you are not rightly confident in what it's worth and how the value might change over time.

Keep in mind that knowing one's own capabilities and limits is easily as important -- if not more important -- as knowing the capabilities and limits of a particular investment opportunity.

Is it possible to buy/sell based upon the above ratings and reliably translate those actions into satisfactory real world future long-term results?

Someone may know how to do this but consider me a bit skeptical.

Will the performance of these ratings prove persistent over the long haul? What's the basis for figuring that out?

I mean, if such an approach were easy to implement, why isn't there a bunch of successful funds or individual investors out there doing just that?

None of this, of course, necessarily means owning all the highest rated or lowest rated stocks would fail going forward. Nor does it mean some clever though somewhat different approach using these ratings can't be made to work. I just think it's wise to suspect it would prove far from straightforward to implement and difficult to have justified confidence in beforehand.

Even when something does happen to work it's often difficult to judge how much of it came down to luck versus skill.

There are, in fact, many able analysts and the study of high quality research/analysis can be time well spent.***

Yet, for those who invest in individual stocks, it's likely not wise to delegate the buy/sell decision-making.

Essentially, that's what happens when an investor chooses to buy or sell a stock based upon a someone else's recommendation.

Still, if nothing else, it's at least mildly interesting that the vast majority of actively managed equity funds underperform yet the two studies seem to at least imply there might be a way to do much better than the market as a whole.

Maybe someone will figure out (has figured out?) how to convert these ratings into an approach that produces reasonable or better rewards going forward.
(If so, the results would need to be measured over decades and not just over a few years of future performance. Sometimes, an approach appears to be working until, well, it just doesn't.)

All I know is it won't be me. Even if there's some way to make these ratings work in a reliable way long-term -- and there just might be -- it's just not the kind of thing I'm interested in or capable or doing.

My interest is in figuring out, within a range, what a business is worth and, considering the risks/alternatives, whether it's likely to increase at an attractive rate over the long run. That's challenging enough. The approach taken should be compatible with your own nature. So I'll stick to buying, with the long-term in mind, shares of the businesses I can understand at a discount.

To me, the equity markets need as many market participants as possible focused on valuing individual businesses. A market where the vast majority are engaged in estimating per share intrinsic business value should at least be somewhat less likely to get mispriced (by emotions and other factors) in extreme ways.

Others may naturally have a very different view.

Recent bubbles (i.e. extreme and widespread mispricings on the high side) have revealed at least some of the economic consequences of broad-based mispriced assets.

There's certainly room for speculation in financial markets, and maybe even some gimmickry, but the proportion of participants involved in such things matters. A little bit is fine but at some point more becomes not such a wonderful thing.

Financial markets can and do facilitate the transfer of risk but shouldn't exist primarily to serve those who are inclined to gamble; they exist (or should exist) mostly to move capital that's been priced as appropriately as possible -- with an emphasis on long-term effects -- where it needs to be.

Adam

* Sources: Bespoke Investment Research and Bloomberg. The S&P 500 returned 6.5% annually over the same time frame. So it's not like the highest rated stocks did badly. Not at all. It's just that the lowest rated stocks did even better.
** In the episode, George Costanza implements an effective strategy to overcome his innately terrible instincts: 

"A job with the New York Yankees! This has been the dream of my life ever since I was a child, and it's all happening because I'm completely ignoring every urge towards common sense and good judgment I've ever had." - George Costanza in "The Opposite"

Maybe the approach isn't as crazy as it sounds.
*** Though, at least for me, it all starts with an in-depth review and analysis of the 10-Ks and 10-Qs over as many years as possible (depending on the business). Reading widely -- and thinking carefully about a particular investment -- is a crucial part of the investment process.
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