Investments, tenth edition

   Stock Market Analysts 

 Stock market analysts historically have worked for brokerage firms, which presents an 

immediate problem in interpreting the value of their advice: Analysts have tended to be 

overwhelmingly positive in their assessment of the prospects of firms.  

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   For example, on 

a scale of 1 (strong buy) to 5 (strong sell), the average recommendation for 5,628 cov-

ered firms in 1996 was 2.04.  

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   As a result, we cannot take positive recommendations 

(e.g., to buy) at face value. Instead, we must look at either the relative enthusiasm of ana-

lyst recommendations compared to those for other firms, or at the change in consensus 

recommendations.

 

 Womack  

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   focuses on changes in analysts’ recommendations and finds that positive 

changes are associated with increased stock prices of about 5%, and negative changes 

result in average price decreases of 11%. One might wonder whether these price changes 

reflect the market’s recognition of analysts’ superior information or insight about firms 

or, instead, simply result from new buy or sell pressure brought on by the recommenda-

tions themselves. Womack argues that price impact seems to be permanent, and therefore 

    11.5 

Mutual Fund and Analyst Performance 

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P A R T   I I I

  Equilibrium in Capital Markets

consistent with the hypothesis that analysts do in fact reveal new information. Jegadeesh, 

Kim, Krische, and Lee  

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   also find that changes in consensus recommendations are associ-

ated with price changes, but that the  level  of consensus recommendations is an inconsistent 

predictor of future stock performance.

  

 Barber, Lehavy, McNichols, and Trueman  

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   focus on the level of consensus recom-

mendations and show that firms with the most-favorable recommendations outperform 

those with the least-favorable recommendations. While their results seem impressive, the 

authors note that portfolio strategies based on analyst consensus recommendations would 

result in extremely heavy trading activity with associated costs that probably would wipe 

out the potential profits from the strategy.

 

 In sum, the literature suggests some value is added by analysts, but ambiguity remains. 

Are superior returns following analyst upgrades due to revelation of new information or 

due to changes in investor demand in response to the changed outlook? Also, are these 

results exploitable by investors who necessarily incur trading costs?