Realistically, if the analysts aren’t wearing any clothes yet, they soon will be if they follow their own investing prowess. While the motivating factors of why to rate a company a “Buy” or “Hold” or “Sell” have long been debated, the reality is that most individual investors continue to be misled by them. The dirty little secret on Wall Street is that those ratings mean nothing and are given no credibility by professional investors. Every institutional investor has made it abundantly clear that they could care less what large brokerage firms rate individual companies. So who are these ratings for? A new study once again demonstrates… it’s for the little guy & gal. Joe the Investor gets the shaft again.
We have argued that the usage of ratings by investment banking firms have long been suspect, and statistically they are usually no better than flipping a coin. However, if Professor Baker’s findings from San Diego State University hold true, it appears the ratings may have great value indeed! So long as you always do the exact opposite of what Wall Street says you should do.
According to Baker, and his research partner Mario Ramos, it appears that between 1998 and 2005, investors would actually do better buying the “Sell” rated stocks and shorting the “Buy” rated stocks. The study itself has not been released yet, and often the mathematical assumptions from the academic community can be a bit remiss in identifying valid correlations to stock price movement, but we imagine that the good professors are accurate enough to release such findings.
Professor William E. Baker, San Diego State University
CHANGES IN ANALYST RECOMMENDATIONS are significant events reported to investors and are often accompanied by analyst interviews and comments. Despite long-running doubts regarding their expertise and motives, they remain the high priests of equity performance prediction.
My new study with Mario Ramos at San Diego State University shows the emperor has no clothes. We examined the accuracy of analyst recommendations from the point of view of the individual investor. Analyst performance was studied for the Dow Jones Industrial Average and the Standard & Poor’s 500 over a seven-year period beginning in January 1998 and ending in December 2005. In both studies, the performance recommendations were tracked from their initiation to their termination.
Results were sobering. The average net performance of Dow Jones Industrial Average stocks with Buy, Hold and Sell ratings was 1.0%, 2.4% and 2.0%, respectively. The results for the S&P 500 technology sector were worse. Statistically, stocks with Buy ratings underperformed stocks with Hold and Sell ratings. The average net performance of stocks with Buy, Hold and Sell ratings was 4.4%, 7.9% and 8.3%, respectively.
Although harsh, one may conclude from these findings that, as a whole, the analyst community either has no real stock-picking expertise or they have expertise, but they have been corrupted by conflicts of interest. The Sarbanes-Oxley Act was supposed to deal with conflict of interest issues, but results from this study suggest it has failed. Our analysis examined whether the accuracy of analysts’ predictions improved after Sarbanes-Oxley was passed. At least through the time period of the study, Sarbanes-Oxley had no impact on accuracy. If anything, analyst’s performance deteriorated.
Moreover, Professor Baker has brought up the possibility of possible FTC action. The Federal Trade Commission may certainly view the materially omitted fact by Wall Street investment firms that their ratings have abysmal performance as a criteria raising these research reports to the level of deception. That is a serious charge, and certainly one that will not be taken lightly by both investment banks and regulators.
What can be done? The Federal Trade Commission established three criteria to assess deception: likelihood, materiality and reasonableness. Consumers can be deceived not only by what is in an appeal or representation, but also by what is omitted, particularly if the omitted information is important to understanding its implication. The fact that recommendations are worthless is certainly a piece of omitted information that could be helpful to investors.
The FTC is likely to infer the materiality of omitted information if the purveyor of that information knew or should have known that consumers needed the omitted information to evaluate the product or service.
The third FTC criterion is reasonable consumers. The reasonable standard is generally presumed to be met if the practice has the capacity to mislead 20% to 25% of the targeted group. Our follow-up research with more than 700 individual investors with online-trading accounts indicates that 51% of the respondents reported being influenced by analyst recommendations at least some of the time. Seventy-one percent and 85% of respondents at least moderately agreed with the statement that stocks with Buy ratings outperform stocks with Hold ratings and Sell ratings, respectively.
A recent Supreme Court ruling, Roberts v. the FTC (2002) opens the door to the FTC’s involvement in the securities industry.
As stated before, research ratings by investment banks have long been suspect. The Global Research Analyst Settlement was brought about by Elliot Spitzer in an effort to make sure that conflicts of interest would not alter ratings from investment banks. We have long felt that there is value in the research provided by these shops but it has nothing to do with their B/H/S ratings. It is our belief that firms engaged in investment banking should be removed from the “ratings game” all together. After all, it doesn’t appear that they are any good at it anyway. These results do not even take into account the recent downturn, and none of these firms had many sell ratings coming into this recession.
It remains to be seen how this study will be received by the investment community, and just as importantly, the FTC. Some Wall Street firms that could potentially be effected by such an action by the FTC include, but are not limited to: Goldman Sachs (GS), Morgan Stanley (MS), and Citigroup (C).