Can Investors Profit from the Prophets? Security Analyst Recommendations and Stock Returns

Abstract

We document that purchasing~selling short! stocks with the most~least! favorable consensus recommendations, in conjunction with daily portfolio rebalancing and a timely response to recommendation changes, yield annual abnormal gross returns greater than four percent. Less frequent portfolio rebalancing or a delay in reacting to recommendation changes diminishes these returns; however, they remain significant for the least favorably rated stocks. We also show that high trading levels are required to capture the excess returns generated by the strategies analyzed, entailing substantial transactions costs and leading to abnormal net returns for these strategies that are not reliably greater than zero. THIS STUDY EXAMINES WHETHER INVESTORS can profit from the publicly available recommendations of security analysts. Academic theory and Wall Street practice are clearly at odds regarding this issue. On the one hand, the semistrong form of market efficiency posits that investors should not be able to trade profitably on the basis of publicly available information, such as analyst recommendations. On the other hand, research departments of brokerage houses spend large sums of money on security analysis, presumably because these firms and their clients believe its use can generate superior returns.

The reaction of investors to analyst recommendations of stocks listed on the WIG20 index

“…Additionally, they confirm the findings from other markets (Womack, 1996;Barber et al, 2001; that the reaction to the recommendation depends on the size of the company and is stronger in the case of smaller firms. A direct and clear relationship between brokerage house reputation and reaction to the recommendation was not found.…”

“…Then, coefficients α 1 1 , j and α 1 2 , j inform us how the intercept changes when CHANGE goes to levels j 1 and j 2 , respectively. Analogously, coefficients α 3 1 ,k and α 3 2 ,k represent the change in the intercept when variable RANKING goes from the reference level to levels k 1 or k 2 .…”

“…Some authors consider additional factors that influence investor reaction; one of which the size of the company. Results obtained by Womack (1996), Barber et al (2001), , and suggest that the strongest reaction to recommendations is observed in the case of small-and medium-sized companies.…”

“…They also find that analyst recommendations have a stronger impact on smaller firms. As mentioned by Barber et al (2001), this relationship between company size and investor reaction is reasoned. The smaller is the firm, the less informed the public is about it (and as a result, the more unexpected the recommendation).…”

“…Also on the U.S. equity market, Barber et al (2001) group firms into portfolios according to their consensus analyst recommendations and focus on the profitability of investment strategies that involve this consensus. As a part of the research, they partition portfolios according to the size of the firm.…”