Wall Street Shocker!!! “Buy” Ratings Underperform!!

Interesting opinion piece in Barron’s about a recent study comparing the relative performance of stocks rated Buy, Hold, and Sell by Wall Street analysts:

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.

Most folks with industry experience won’t be surprised by these results. However, the author’s primary objective is to implement yet more consumer protections for retail investors:

…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.

Whoa! From the point of "or they have expertise, but…", the author takes an incredible leap. Are there really only two competing explanations? Of course not, and the alternatives are many. For example, it probably takes an analyst longer to revise a rating based on new information than it takes the market to incorporate that information in prices; another structural issue is the existence of "stale" ratings (I haven’t seen the study, so don’t know whether this was controlled for). It’s also quite likely that basic human behaviors are at work, e.g., the typical analyst might reconsider their view of a stock if the market prices calls it into question, thus "Sell" rating are put on stocks that have already been sold off, and vice versa. It takes a lot of courage to call the market wrong, and most people find herd behavior preferable to loneliness. In my experience, most analysts are skilled at analysis; very few is any are skilled at prediction. Thus, insofar as stock ratings are seen by users as predictions of market behavior, it shouldn’t be surprising to anyone that the average stock rating is less than worthless (again, assuming the authors controlled for important structural inefficiencies like the ones mentioned above).

It’s also my experience that most analysts are good people, and that most firms do not engage in the unethical, even criminal, behavior that the author seems to insinuate. Those behaviors undoubtedy happen (again, basic human behavior), but as in most civilized societies and insitutions, they are the exception and not the rule. 

The author takes none of this into consideration, and instead argues for additional government regulation of the securities industry by bringing securities research under the auspices of the Federal Trade Commission. If you’ve seen a research report in recent years, especially from a large wirehouse, it’s astounding how many pages are dedicated to legal disclaimers. Apparently the author sees room for more. I harbor little doubt that excessive human and financial resources are expended on securities research, or that the odds of success are stacked against most individual investors. However, just as there are many competing explanations for the study’s findings, there are many competing solutions to the problem. I think an important answer lies in education, e.g., through dissemination of study findings like these (hold the conclusions?!?), and more fundamentally, by introducing economics and finance requirements into elementary education. Contrary to prevailing cultural impressions of Wall Street, it isn’t rocket science, and it doesn’t require anything remotely as arduous as medical school. The lack of remedial financial education is one of the most important educational gaps in our system.

We do see a sliver lining in this study, and it’s the finding that Sarbanes-Oxley, in at least one important respect, has not only failed to improve things, but has actually made them worse. It’s completely logical to assume that Sarbox chased talented analysts into positions where their stock ratings were not publicly disseminated. Perhaps the author ought to question his "more is better" approach to regulation.

URLs:

http://online.barrons.com/article/SB122895208808896233.html?mod=djemBF 

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