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Do investment analysts provide positive returns for investors? That is, are you better off if you find a top analyst and follow his or her recommendations?

The evidence is not encouraging for those that wish to follow recommendations of analysts.

I think that there are some very good analysts in the business. And I think that the average analyst does a decent job of following the companies in his or her area of expertise. But does that translate into recommending that you find one or more and follow their calls? No.

I shall give you two reasons why I feel this way.

Analysts May Be Too Optimistic

One, analysts may tend to be overly optimistic in their assessments.

There are a variety of explanations as to why analysts tend towards optimism. I am not sure that I fully ascribe to any of them, but I shall point out the common ones quickly.

Existing or potential investment banking relationships between companies and their bankers may result in pressure on that bank’s analysts to provide positive assessments of the company. Usually the pressure comes in the form of employee remuneration or promotion opportunities. In some ways, I can see this occurring, especially when trying to attract new companies as clients for underwriting and other corporate finance work. But investment bankers often separate their finance groups from their research groups to try and maintain an appearance of objectivity.

Brokerage houses make money on investor commissions. Positive research reports may generate increased purchases and greater transaction revenues for the broker. There is some merit in this argument. Maybe I am a little naive, but I am not sure of the long-term benefits in brokers over-hyping stocks. Say I consistently read research reports, bought shares on the recommendations, and then saw under-performance as compared to the recommended share’s target prices. It would not take me long to a) no longer consider the research reports as having any informational value, and b) find a new brokerage house.

The analyst and/or his firm has a financial interest in the company being reported on. Again, this can be a legitimate concern for investors. In many jurisdictions though, there should be statutory disclosure requirements for any potential financial conflicts.

Most relevant professional organizations have ethical requirements concerning this and other issues relating to potential conflicts of interest. For example, the Chartered Financial Analyst “Code of Ethics & Standards of Professional Conduct” has quite detailed standards.

In a word, disclose. When you watch analysts on FOX Business, Business News Network, Bloomberg, etc., there is normally a statement as to whether the analyst, his family, or firm have a financial interest in the securities discussed.

For me, the common reasons as to why analysts are optimistic are a little tenuous.

However, that does not mean analysts are not optimistic in their estimates. In fact, there is evidence to suggest that analysts are indeed too optimistic.

In April of 2010, McKinsey Quarterly wrote that “Equity analysts: Still too bullish”.

“Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.

Alas, a recently completed update of our work only reinforces this view—despite a series of rules and regulations, dating to the last decade, that were intended to improve the quality of the analysts’ long-term earnings forecasts, restore investor confidence in them, and prevent conflicts of interest.”

The authors show that the over-optimism is significant as well as consistent.

“… analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent.”

Even though regulatory agencies and professional organizations are working to strengthen analyst objectivity, there still appears to be a bias (intentional or otherwise) towards inflation of expected performance.

While I do not fully support the complaints outlined above, I think that there is a bit of credence to them as to the reason for bias. The weaker the regulatory environment, the greater the probability for problems.

But I believe the key factor for optimism is less sinister. It likely stems from the fact that the analysts spend much of their time listening to the companies they follow. As a result, they hear positive takes on new products, cost cutting measures, and earnings growth.

They also want to keep a good relationship with companies they track. I know of more than a few stories where analysts have been frozen out of companies that they follow because they questioned a company’s data or gave less than glowing assessments. Given that access to the company is crucial when trying to analyze it, this can have an impact on analysts.

How Can You Determine The Best Analysts?

Two, it may be difficult to identify a “top” analyst whose recommendations you can follow.

Analysts tend to specialize in specific industries. Unless you plan to invest in only one or two industries, you will have to determine top analysts in multiple categories.

Also, with many analysts to assess there are many analysts vying for recognition each year. And there may be substantial change in “top” analysts every year.

For example, on August 6, 2012, Business Insider provided readers with, “The 36 Best Analysts On Wall Street”. I am sure an excellent group.

A year later, on August 16, 2013, Business Insider offered 50 names in, “The Best Stock Analysts In America”.

Maybe I missed a name or two in my comparison, but I think only Betsy Graseck made both lists. In one short year, very little concurrence on who are the top analysts.

The shift from year to year is normal within investment categories.

That much change makes it difficult to try and follow specific analysts who you may believe are best in class.

Is Following the Pros a Waste of Time?

I do not think it wise to develop a strategy of following analyst recommendations.

But you should rely on the research reports in your own analysis. The information contained therein is usually pretty good and can help you form your own conclusions. And if you know the limitations and concerns about research reports as described above, you can factor them into your own analysis.

In the future, we will return to this topic. Specifically, how you should utilize research reports in your personal analysis. We will also consider the suitability of attempting to follow the same investment strategies of highly successful investors (e.g., Warren Buffet). But we will save that for a future date.

Next up, a we begin to look at the passive versus active management debate. Also known as, can fund managers beat their benchmarks? And, as we will see, paying a professional to manage your money is often not the wisest strategy.