Yesterday, we discussed that some analysts at major firms have been "tweaking" and "correcting" their prior ratings and up/downgrade history. This was done apparently to improve their historical track records. Of course, not everyone did this; the professors who authored the study found "only" 54,729 non-random, ex-post changes out of 280,463 (19.5%). Based on those numbers, we can presume many of the analysts who participate in the I/B/E/S rating system are ethical — or at least were unwilling to game the system or make changes to ratings after the fact.
A quant study from Merrill’s Bernstein — released prior to this news breaking — takes a different, contrary to the crowd tack. It turns out that the stocks in the S&P 500 with the least analyst coverage outperformed the rest in 2006 — and quite handily, also:
"BEFORE 2006 SLIPS AWAY FURTHER into the mists of history, we might pass along some conclusions about that surprising, rewarding and rambunctious year we found especially interesting. They’re from the pen of Rich Bernstein, Merrill Lynch’s chief investment strategist, who, despite that ominous title, is a sensible and knowing observer of the stock market.
More specifically, Rich addressed the question of what were the best performing investment strategies in ’06 among the 40 or so tallied by the firm’s quants, rather a logical subject for a leading brokerage house’s No. 1 strategist. Why do we find it more than a little deliciously ironic that he discovered that the very best strategy was buying stocks with scant analyst coverage? Maybe it had something to do with the fact that, at last count, Merrill employed no fewer than 750 analysts in its global research network.
In any case, Rich asserts that the investor who concentrated on the 50 stocks in the S&P 500 that are followed by the fewest Wall Streets analysts wound up with a rousing 24.6% gain in the 12 months ended Dec. 29. That handily beats the quite decent 13.6% advance of the S&P 500, or, for the matter, the 14.6% rise by the index when calculated on an equally weighted basis.
Which — how could it not? — brought to mind that wonderful piece of advice rendered years ago by that famous curmudgeon and demon investor Gerald Loeb as to what ordinary folks investing in equities ought to remember about security analysts: "In bull markets, you don’t need ‘em; in bear markets, you don’t want ‘em." (emphasis added)
Fascinating stuff. Other strategies that outperformed the S&P500′s 13.6% gains: Stocks that had low price-to-cash-flow multiples (23%), and those with a high dividend yield (21.7%);
Weakest strategy? Growth did a little better than cash (5.7%) — "despite the consensus at the beginning of the year that ‘growth would outperform value in 2006, investors who stayed with value and out-of-favor stocks’ racked up the best returns."
My question to Bernstein & Co. is this: How has this approach worked in the past? Is it only a 2006 phenomena, or has it been successful in years prior?
So while we ponder what this brewing ethical quamire of analyst ratings means to the industry and to investor confidence, there may be another lesson embedded in this for stock pickers: Look for stocks off the beaten path, and away from the best known, best covered names.
Note: This post adds the category "Quantitative"
Skeleton at the Feast
Barron’s Monday, January 8, 2007
Blame the professors: Just as the option backdating scandal started with academic researchers noting mathematical anomalies, so too might the next brewing scandal: the I/B/E/S Analyst ratings back dating scandal.
According to a Barron’s article by Bill Alpert (buried on page 39), several professors have discovered what they describe as 54,729 non-random, ex-post changes out of 280,463 observations — a little over 19.5% of analyst recs (abstract below):
"The professors found
almost 55,000 changes that had been made in the I/B/E/S database of
stock-analyst recommendations maintained by Thomson, the Stamford,
Conn., firm that is a leading vendor of financial data. The alterations
made Wall Street’s record of recommendations look more conservative –
hiding Strong Buy recommendations and adding Sell recommendations from
1993 to 2002. That is a period for which Wall Street has drawn heat and
government sanctions for touting Internet bubble stocks.
As a result of the changes, the stock picks shown in
the database would have created annual gains that were 15% to 42%
better than the originally recorded recommendations, using a trading
strategy based on analysts’ recommendations."
The firms were the most significant participants in the data backdating were also the firms who had the closest relationship between banking and research and were the hardest hit by the Spitzer enforced settlement.
From page four of the academic working paper notes exactly how significant this was:
"Why do the historical data now look different than they once did? The contents of the database changed at some point between September 2002 and May 2004, a period that not only coincided with close scrutiny of Wall Street research by regulators, Congress, and the courts, but also saw a substantial downsizing of research departments at most major brokerage firms in the U.S.
The paper outlines four types of data changes: 1) non-random removal of analyst names from historic recommendations (anonymizations); 2) the addition of new records not previously part of the database; 3) the removal of records that had been in the data; and 4) alterations to historical recommendation levels.
The net result of this was to make many specific trading strategies appear better in retrospect than they actually were. Buying top rated stocks and shorting lowest rated stocks, based on the changed data, now perform 15.9% to 42.4% better on the 2004 revised data than on the 2002 tape, the professors state.