Authors: Anders Anderson, Howard Jones, and José Martinez
Whether equity analysts add any value and who captures that value are questions addressed in a recent academic paper using data from the Stockholm Stock Exchange. It finds that analysts do add value, which is shared between the brokers for which they work and the investors who follow their recommendations.
The Stockholm Stock Exchange (SSE) is well suited for this type of study because, as a pure limited-order market with only brokerage firms as members, it allows a clear link to be made between a broker’s recommendations and the trades it executes for its clients. The dataset comes from a ten-year period to 2006, but the structure of the SSE has not changed materially since then.
The study measures abnormal profits rather than abnormal returns. In the authors’ opinion, normal returns, which reflect the relative share performance of a stock from the record date of a recommendation change (up or down), ignore two important facts: first, that some investors get the recommendation change before the record date, e.g. because they are tipped off early as favoured clients; and secondly, that investors cannot always execute the trades they want and so may miss out on these returns. Abnormal profits, by contrast, measure actual profits that can be attributed to the recommendation change itself, and they take into account both pre-record date trading and the investability of the recommended share at the time.
Misleading abnormal returns
Indeed, the study confirms how misleading abnormal returns can be. Half of the profits obtained by investors who follow recommendation changes are made before the record date of the change – this would not be captured by an abnormal return approach. And even allowing for this, there are two types of recommendation change which show impressive returns but meagre profits. These are recommendations of small-caps and downgrades of all stocks, large or small. The failure of investors to capitalize on small-cap recommendations no doubt reflects their poor investability, while the unprofitability of downgrades is attributed to the tendency of downgrades to be a response to bad news, so that they lag, rather than lead, the market.
Overall, this paper finds that recommendation changes do add value, largely reflecting upgrades of large-caps. But who benefits? The direct beneficiaries are the investors who follow the recommendations: they profit to the tune of around $80,000 per recommendation. However, the indirect beneficiaries are the brokers themselves who, thanks to the higher turnover they generate by their recommendations and the higher commissions they charge for recommendation-induced trades, recoup from those investors at least 40–60% of the abnormal profits of investors.
The conclusion that at least half of the abnormal profits generated by analysts’ recommendations end up with the brokers for which they work should be comforting for analysts, but it is also reassuring in terms of efficiency: the benefit of investment expertise is captured, at least in part, by those who possess it.
Anders Anderson is the director of the Swedish House of Finance at the Stockholm School of Economics.
Howard Jones is associate professor of finance at the Saïd Business School at the University of Oxford.
José Martinez is assistant professor of finance at the University of Connecticut School of Business.
Read the full paper Measuring The Value Of Stock Recommendations