INFORMATIONTRADING:FOLLOWINGTHEANALYSTS

AswathDamodaran

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Analysts:Thecaseforinformationadvantages

¨ Analystshaveaccesstopublicinformationandtothemanagersofthefirm(andthusperhapstoprivateinformation).

¨ Analystsare“sector”specialistswhocanusetheirknowledgetobetterassessvalueforindividualcompanies.

¨ Analystsmakeearningsforecastsforfirms(andrevisethem)andrecommendationsonbuyandsell.

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Whodoanalystsfollow?

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Determinantsofanalystfollowing…

1. MarketCapitalization:Thelargerthemarketcapitalizationofafirm,themorelikelyitistobefollowedbyanalysts.

2. InstitutionalHolding:Thegreaterthepercentofafirm’sstockthatisheldbyinstitutions,themorelikelyitistobefollowedbyanalysts.Theopenquestion,though,iswhetheranalystsfollowinstitutionsorwhetherinstitutionsfollowanalysts.Giventhatinstitutionalinvestorsarethebiggestclientsofequityresearchanalysts,thecausalityprobablyrunsbothways.

3. TradingVolume:Analystsaremorelikelytofollowliquidstocks.Hereagain,though,itisworthnotingthatthepresenceofanalystsandbuy(orsell)recommendationsonastockmayplayaroleinincreasingtradingvolume.

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I.EarningsForecasts

• Analystsspendaconsiderableamountoftimeestimatingtheearningspersharethatcompanieswillreportinthenextquarter.Theyalsoprovideforecastsofearningsfurtherout- upto5years.

• Analystsalsoconstantlyupdatetheseforecastsasnewinformationcomesout.Totheextentthatthereisinformationintheserevisions,stockpricesshouldreact.

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InformationinEarningsForecasts

• Firm-specificinformationthathasbeenmadepublicsincethelastearningsreport:Analystscanuseinformationthathascomeoutaboutthefirmsincethelastearningsreport,tomakepredictionsaboutfuturegrowth.

• Macro-economicinformationthatmayimpactfuturegrowth:Analystscanupdatetheirprojectionsoffuturegrowthasnewinformationcomesoutabouttheoveralleconomyandaboutchangesinfiscalandmonetarypolicy.

• Informationrevealedbycompetitorsonfutureprospects:Analystscanalsoconditiontheirgrowthestimatesforafirmoninformationrevealedbycompetitorsonpricingpolicyandfuturegrowth.

• Privateinformationaboutthefirm:Analystssometimeshaveaccesstoprivateinformationaboutthefirmstheyfollowwhichmayberelevantinforecastingfuturegrowth.

• Publicinformationotherthanearnings:Ithasbeenshown,forinstance,thatotherfinancialvariablessuchasearningsretention,profitmarginsandassetturnoverareusefulinpredictingfuturegrowth.Analystscanincorporateinformationfromthesevariablesintotheirforecasts.

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TheQualityofEarningsForecasts

¨ Betterthanusinghistoricalearnings:Thegeneralconsensusfromstudiesthathavelookedatshort-termforecasts(onequarteraheadtofourquartersahead)ofearningsisthatanalystsprovidebetterforecastsofearningsthanmodelsthatdependpurelyuponhistoricaldata.Themeanrelativeabsoluteerror,whichmeasurestheabsolutedifferencebetweentheactualearningsandtheforecastforthenextquarter,inpercentageterms,issmallerforanalystforecaststhanitisforforecastsbaseduponhistoricaldata.

¨ Butnotbymuchandonlyselectively:Astudyin1978measuredthesquaredforecasterrorsbymonthoftheyearandcomputedtheratioofanalystforecasterrortotheforecasterrorfromtime-seriesmodelsofearnings.ItfoundthatthetimeseriesmodelsactuallyoutperformanalystforecastsfromApriluntilAugust,butunderperformthemfromSeptemberthroughJanuary.

¨ Andforthenearterm:TheotherstudybyO'Brien(1988)foundthatanalystforecastsoutperformthetimeseriesmodelforone-quarteraheadandtwo-quarteraheadforecasts,doaswellasthetimeseriesmodelforthree-quarteraheadforecastsanddoworsethanthetimeseriesmodelforfour-quarteraheadforecasts.

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AnalystErrorsseemtoberelatedtomacroeconomicconditions…

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Howaboutlongtermforecasts?

¨ Thereislittleevidencetosuggestthatanalystsprovidesuperiorforecastsofearningswhentheforecastsareoverthreeorfiveyears.¤ AnearlystudybyCraggandMalkiel comparedlong-termforecastsbyfiveinvestmentmanagementfirmsin1962and1963withactualgrowthoverthefollowingthreeyearstoconcludethatanalystswerepoorlongtermforecasters.

¨ Thisviewwascontestedin1988byVanderWeide andCarletonwhofoundthattheconsensuspredictionoffive-yeargrowthintheI/B/E/Swassuperiortohistoricallyorientedgrowthmeasuresinpredictingfuturegrowth.

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MarketReactiontoEarningsRevisions…

¨ Earningsrevisionsandstockreturns:Inoneoftheearlieststudiesofthisphenomenon,GivolyandLakonishokcreatedportfoliosof49stocksinthreesectors,baseduponearningsrevisions,andreportedearninganexcessreturnon4.7%overthefollowingfourmonthsonthestockswiththemostpositiverevisions.

¨ Extremerevisions:Hawkins,in1983,reportedthataportfolioofstockswiththe20largestupwardrevisionsinearningsontheI/B/E/Sdatabasewouldhaveearnedanannualizedreturnof14%asopposedtotheindexreturnofonly7%.

¨ NeartermvsLongterm:Inanotherstudy,Cooper,DayandLewisreportthatmuchoftheexcessreturnsisconcentratedintheweeksaroundtherevision–1.27%intheweekbeforetheforecastrevision,and1.12%intheweekafter,andthatanalyststhattheycategorizeasleaders(basedupontimeliness,impactandaccuracy) haveamuchgreaterimpactonbothtradingvolumeandprices.

¨ Inothercountries:In2001,Capstaff,PaudyalandReesexpandedtheresearchtolookatearningsforecastsinothercountriesandconcludedthatyoucouldhaveearnedexcessreturnsof4.7%intheU.K,2%inFranceand3.3%inGermanyfrombuyingstockswiththemostpositiverevisions.

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PotentialPitfallsandpossibleuse…

¨ Weakestlinks:Thelimitationofanearningsmomentumstrategyisitsdependenceontwooftheweakestlinksinfinancialmarkets –earningsreportsthatcomefromfirms(whereaccountinggamesskewearnings)andanalystforecastsoftheseearnings(whichareoftenbiased).

¨ Clienttrading:Totheextentthatanalystsinfluencetradesmadebytheirclients,theyarelikelytoaffectpriceswhentheyreviseearnings.Themoreinfluentialtheyare,thegreatertheeffecttheywillhaveonprices,butthequestioniswhethertheeffectislasting.

¨ Shortterm:Itisashort-termstrategythatyieldsfairlysmallexcessreturnsoverinvestmenthorizonsrangingfromafewweekstoafewmonths.

¨ Keyanalysts:Onewayyoumaybeabletoearnhigherreturnsfromthisstrategyistoidentifykeyanalystsandbuildaninvestmentstrategyaroundforecastrevisionsmadebythem,ratherthanlookingatconsensusestimatesmadebyallanalysts.Whileforecastrevisionsandearningssurprisesbythemselvesareunlikelytogeneratelucrativeportfolios,theycanaugmentothermorelong-termscreeningstrategies.

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II.Recommendations:Somebackground

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MarketReaction…

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Temperedbyfearsofbias…

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UsingAnalystRecommendations…

• Canyoumakemoneyoffanalystrecommendations?– Stockpricesshouldgouponrecommendations,evenifthereisnonew

informationinthem,becausethereisaselffulfillingprophecy.– Ifthisistheonlyreasonforthestockpricereaction,though,thereturns

arenotonlylikelytobesmallbutcouldveryquicklydissipate.• Afourstepprocesstogettingthemostoutofanalysts:

– Identifytheanalystswhoarenotonlythemostinfluentialbutalsohavethemostcontent(privateinformation).Recommendationsbackedupbynumbersandasolidstoryhavemorehefttothem.

– Screenoutanalystswherethepotentialconflictsofinterestaretoolargefortherecommendationstobeunbiased.

– Youshouldinvestbasedupontherecommendations,preferablyatthetimetherecommendationsaremade.

– Assumingthatyoustillattachcredencetotheviewsoftherecommendinganalysts,youshouldwatchanalystsforsignalsthattheyhavechangedorarechangingtheirminds.

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Aflatterinvestmentworld?

¨ Analystadvantageshaveshrunk:Theadvantagesthatanalystshaveoverotherinvestorshasshrunkifnotdisappearedformanyreasons:¤ Therulesoninsiderinformationhasbecomemuchmorestringentaroundthe

world,andespeciallysoinEuropeandtheUS,makingitalmostimpossibleforcompaniestopassontangibleinformationjusttoanalysts.

¤ Accesstodata(companyfilings,managementdiscussions,evenanalystreports)hasbeendemocratized.

¤ Powerfultoolsarenolongersoexpensivethatonlythelargeinstitutionscanaffordthem.

¨ Analystsplaythepricinggame:Analystsarejudgedbaseduponhowtheirrecommendationsplayoutintheshortterm,notthelongterm.Hence,theirinterestslielessinvalueandmoreinprice.

¨ Adifferentstrategy? Thefactthatthegamehasevenedoutandthatanalystsplaythepricinggamemayallowinvestorstoplayoffanalyst-drivenmispricingtomakemoney.