Are Stock Recommendations Useful?

We’re hearing a lot these days about stock market analysts and the accuracy of their recommendations. What factors come into play when it comes to picking stocks?
The issue of stock picking was big during the tech bubble at the beginning of this decade, and it has resurfaced again with the latest economic downturn. During the tech bubble, analysts had strong ‘buy’ recommendations on companies that quickly proved to be unprofitable. Their failure to exercise good judgement during this period led to a raft of new regulation being applied to the industry, both in the U.S. and internationally. Two of my recent papers, co-authored with Ran Barniv (Kent State), Mark Myring (Ball State) and Wayne Thomas (Oklahoma) analyze how analysts go about making recommendations, how these recommendations map onto future stock returns, how regulations affect the way analysts work, and how these elements vary across countries.

The larger question is, are stock recommendations useful to investors? In a perfect world, you would expect an analyst to examine a company using firm-specific, industry-specific and macro-level data, and then come up with an estimated value for that company, based on a model that takes into account future earnings or cash flows. If the company’s estimated value is greater than today’s stock price, the analyst would issue a buy recommendation, and conversely, if it is below that day’s stock price, he would issue a sell recommendation. It seems obvious that there should be a positive relation between stock recommendations and analysts’ intrinsic value estimates based on their forecasts of future earnings, but that is not what we observed.

Stock recommendations and valuation estimates are not related in the way you would expect. Instead, recommendations relate positively to ‘heuristics’, that is, the price-to-earnings to growth (PEG) ratio and long-term growth rates. Our findings suggest that analysts give the highest recommendations to growth stocks, and among growth stocks, they give the highest recommendations to firms for which the value of growth estimated by the PEG model exceeds the current stock price.  So something else is going on.

What are analysts basing their recommendations on, if not a company’s earnings?
Clearly, if analysts didn’t provide any useful information whatsoever, they wouldn’t be in business. But they also have other incentives, such as the need to gain investment banking business, or to curry favour with management. Pragmatic considerations come into play. During a conference-call session, if you are providing forecast recommendations that management doesn’t like, you are not likely to be able to ask a question of the company. You will gain greater access if your stated views are positive than if they are negative. Such pragmatic considerations play more of a role in stock picking than you might expect.

Your research actually uncovered a negative relation between analysts’ recommendations and stock returns. Please discuss this remarkable finding.
Firstly, it is rather surprising that analysts give more favourable recommendations to stocks with lower valuation estimates (based on residual income models) relative to current price. The valuation estimates, developed using analysts’ earnings forecasts, relate positively to future excess stock returns. In other words, earnings forecasts are useful inputs into valuation models, yet they tend to relate negatively or insignificantly to stock recommendations.

Why do analysts appear to avoid using valuable earnings forecasts in a sophisticated manner in setting their recommendations? This surprising result motivated us to examine the issue further, both in a single-country setting (the U.S.) and a multi-country setting. In our first study, we examined the effects of recent regulations in the U.S. market and found that analysts’ recommendations have in fact become more closely related to their valuation estimates since the regulations came into force. However, stock recommendations continue to relate negatively with future returns, even in the post-regulation period. We concluded that the regulations have affected analysts’ output – forecasted earnings and stock recommendations – but that investors should be aware that factors other than identifying mispriced stocks continue to influence analysts’ recommendations.

Our second paper was the first large study to examine the relationship between recommendations, earnings forecasts and future excess returns in an international context. In it, we showed that in international markets in which analysts’ ‘other incentives’ are less pronounced than in the U.S., their stock recommendations are more closely aligned with valuation estimates, less closely aligned with ‘heuristics’, and positively associated with future returns.

Overall, our findings are consistent with the idea that analysts are affected by incentives other than maximizing returns to investors. Furthermore, regulations can have an effect, but we shouldn’t expect them to completely solve the problem.

Is effective regulation of the stock market possible?
The problem with regulations in general is that they often go overboard. We see this not just in stock analysis but in financial reporting and other areas where regulations have been applied. You want financial analysts to have some freedom, and to not be overly constrained by rules that stifle innovation. It is difficult to measure the true effects of regulations and to ascertain whether they are doing more harm than good. Based on our research, however, it is clear that the regulations applied after the tech bubble collapsed did have some positive effects. The analyst industry was so distorted that something had to be done, and the solution did not seem to be coming from within. The profession itself could have made an effort to self regulate, but they missed that opportunity, creating a need for multiple regulators to step in and protect investors. Once the regulations were put into place, the quality of stock picks improved.

How can investors filter what they are hearing from analysts in order to gain a more accurate picture?
Investors should first be aware of the distribution of stock recommendations. In a perfect world, you would expect half of recommendations would be to buy and half to sell, yet most stock recommendations are buy recommendations. This means that statistically, many of these recommendations will not lead to positive returns. You should also be aware of the relationship between an analyst’s brokerage firm and the company in question. If you know that there is a strong relationship between the two -- for example, that the analyst’s firm underwrites the securities of the company in question -- you should probably take his recommendations with a grain of salt.

Investors should also avoid relying on a single analyst. By casting their net widely and looking at the distribution of recommendations of a particular stock, investors can get a better sense of where a stock is heading. Clearly this takes time, but the more time you are willing to invest, the more you can learn. I advise using the information provided by your analyst in conjunction with other available information. It may seem paradoxical to have to do your own research, since the very point of an analyst is to do that for you and provide a summary of the results, captured in a buy-or-sell recommendation; but as we have seen, it pays to be well informed.

There is a groundswell of dissatisfaction with analysts in the wake of the current economic downturn. How fair is this reaction?
The financial crisis came as a shock to most people, and it might not be fair to place the blame on analysts. Almost everyone – central bankers, ministers of finance and the world’s money managers – was caught off guard. Predicting a crisis of this scale is probably more than you can expect from any individual analyst. That said, what we are seeing now might be a kind of healthy correction to the tendency to place too much faith in analysts and their recommendations. Investors should always be wary of too much ‘cheerleading’: there needs to be a balance of faith and caution. In my teaching, I use the analogy of a marriage or relationship: when you are getting involved with someone, you want to be a little cautious, but not to the point where you cannot make up your mind. The same logic applies whether you are choosing a stock or choosing a mate: if you are too sceptical, you will never fall in love or make an investment; but if you are not sceptical enough, you will have reason to regret it later.

You have also studied a new trend whereby firms from developing countries are acquiring well-known firms in developed countries. What are some of your findings?
In the past few years we have seen a number of high-profile acquisitions of the sort you describe. In most cases, these transactions were accompanied by heated nationalistic fervour in the developing country where the bidding company originated, and by plenty of media discussion about how the acquisition was good for the nation as a whole. This is not what we are used to seeing in big mergers and acquisitions that take place within the limits of the developed world, where the discussion is instead about shareholders and how they will benefit or fail to benefit from the transaction.

Clearly, many factors explain why one firm acquires another: there must be synergies, growth opportunities, increased profitability and so on. But based on our research, we can say that national pride is another potent reason for one firm to acquire another.  In my study, coauthored with Wayne Thomas and Dushyant Vyas [a Rotman PhD student], using a sample of 3,806 cross-border acquisitions, we documented that firms from developing countries pay more to acquire assets in developed countries than do firms from developed countries. Interestingly, within the sample of developing-country bidders, we found that national pride had both statistically and economically-important effects on the purchase premium.  In other words, national pride does not merely register as a blip in the statistical data, it has powerful economic consequences. We examined a sample of 295 acquisitions from developing country firms, and of those, we classified 36 as ‘national pride acquisitions’. Controlling for all other factors, we found there is a strong premium added when an element of national pride is present.

Quite simply, companies from developing countries pay more for their acquisitions, so there is a financial premium to be paid when national pride is involved. An interesting question is where this premium originates, because national pride may be exhibited both on both the buyer’s and the seller’s side. In the developed world, such pride may take the form of defensiveness or protectionism. In the U.S., for example, we have seen a concern that the takeover of port facilities by foreign firms might create a national security risk, or that acquisitions involving computers and technology, such as the purchase of IBM’s personal computer division by China’s Lenovo, might threaten intellectual property. That said, from the evidence based on media articles surrounding the deals, national pride seems to be a more powerful factor on the buyer’s side: a firm from a developing country is willing to pay more for its acquisition because it has more at stake, including the pride of the nation as a whole.

Why does national pride -- a non-economic factor -- play a decisive role in such important economic transactions?
While the existence of national pride considerations could be interpreted as ‘irrationality’ on part of bidding firms, we cannot rule out the existence of alternate underlying rational motives. For example, it is possible that home governments could reward the firms with economic incentives like tax benefits, license granting, easier access to financing, reduced red tape, and so on. We examined a large number of alternative explanations for the national pride premium, and were careful to weed out most of them. For example, we were able to test for the effect of political connections, in situations where a government minister sits on the board of directors of a bidding company. Even when the effect of these connections is removed, national pride remains a powerful force.

There may be an element of pure Psychology at work here. Certainly this would not be the first place where non-economic factors play a role in business decisions, as my colleagues who study the Psychology of the stock market can attest. Managers may be motivated by hubris, or by a strong sense of their personal or national identity. Business leaders have a natural propensity to want to build empires, and this impulse might be even more powerful when they happen to be from a developing country. National pride can magnify individual pride, and culture and history also play a role. For example, a company from India -- a nation that has a history of being ruled by the British Raj -- may gain a special satisfaction from taking over a well-known UK company such as Jaguar.

Furthermore, firms from developing countries may find it easier to indulge in empire building. Because constraints such as corporate governance mechanisms and shareholder activism are not as strong in these countries, CEOs have a freer hand to accomplish their ambitions. In a developing country such as India, for example, a single, powerful company can have more impact on the welfare of the nation as a whole than it would if it were in a more complex economy like that of the United States. These countries are starting from a lower starting point, so they have more to gain by extending their reach.

Ole-Kristian Hope is Deloitte Professor of Accounting and Associate Professor at the Rotman School of Management.

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]