Wall Street analysts are known more for being cheerleaders than having real trading skills. This is demonstrated in the cynical investor saying: “Analysts — don’t need ’em in a bull market, can’t use ’em in a bear market.”
But a July 2019 research paper from Ohio State University’s Fisher College of Business could change that view. The paper, titled “Are Analyst Trade Ideas Valuable?” determined that in many cases the answer is “yes.”
The researchers — Justin Birru, Sinan Gokkaya, Xi Liu, and René Stulz — conducted a study of 4,543 trading recommendations from Wall Street analysts. These recommendations were distinct from the analysts’ long-term ratings and research reports, and typically covered a time frame of weeks to months.
The trading recommendations turned out to be profitable, and not just by a little bit. According to the paper, the 4,543 recommendations generated “significant abnormal returns” for institutional clients.
For the buy-based recommendations, the researchers calculated 90 basis points worth of alpha, which is 0.9% per month or 10.8% annualized. For the sell-based recommendations, which were less common, the alpha magnitude was twice as large. For institutions especially, those are impressive numbers.
The interesting question is why trading recommendations from Wall Street analysts would be profitable, when the perceived value of analyst stock ratings (the traditional buy, sell, or hold stuff) is much lower.
The answer may reside in experience and selectivity. The trading recommendations generally came from more experienced analysts, and tended only to come when high conviction was present.
Because making trading recommendations was not the analysts’ main job, in other words, the recommendations they committed to were more carefully selected and thought out.
The researchers point out another key fact: Shorter-term trading recommendations are easier to judge in terms of success or failure. A long-term call on a stock could take years to play out and has many different variables involved. A trading recommendation that lasts three months or less has immediate feedback: It either worked or it didn’t.
For the Wall Street analyst, this makes the act of offering a trading recommendation more risky. If the analyst is too frequently wrong, their career could be penalized.
On top of this, there is usually no set schedule for trading recommendations: While research reports and stock ratings have to be updated regularly, the trade recommendations are more free-flowing, making it easier for the analyst to do nothing, and recommend nothing, when no good ideas are present.
As confirmed by the research paper, the natural result seems to be that:
- Wall Street analysts tend to be careful and committed in their recommendations.
- Most of the trading recommendations came from analysts with more experience.
- Recommendations tend to come when conviction is high and opinions are strong.
- In the absence of strong conviction, trading recommendations are not made.
There is some irony here in that Wall Street analysts are getting better results for a side job — something they aren’t required to do — as opposed to the main job, which is what they focus on day-to-day.
The Wall Street analyst’s main job, which is more or less updating reports and company ratings based on earnings calls and press releases and fact-finding efforts, requires always having an opinion; publishing large amounts of material on a scheduled basis; and routinely extrapolating from minor data points (like whether inventory levels rose or fell by a small percentage).
As a result of this heavy workload and high volume of scheduled output, the Wall Street analyst’s main job tends to produce a significant amount of noise. After all, it is hard to have a smart and timely opinion on every stock. Sometimes, when a situation is muddled or highly uncertain, there is no worthwhile opinion to be had at all. But the nature of the analyst’s main job forces them to opine anyway, like a newspaper that has to fill column inches.
The side job of trading recommendations, in contrast, doesn’t require this constant flow of output. The analyst can wait until a situation truly stands out, and hold back until their opinion truly means something.
To borrow a baseball metaphor that Warren Buffett has used, with trading recommendations, the Wall Street analyst can wait for the “fat pitch.” Whereas to meet the obligations of their main job, which involves the constant updating of research reports, they have to swing at junk pitches like clockwork.
There are at least two lessons here for individual investors. The first one is that, if you are selective and smart, you can find strong trading opportunities for your portfolio. If Wall Street analysts can do it, so can you — and the data now exists confirming their success.
The second more important lesson is that, when patience and conviction are involved, it can be better to think of something as a “side job” rather than a main job — if the distinction helps increase selectivity (like a baseball player swinging at fewer pitches).
To give an example, imagine two investors, A and B. Say that investor A sees their “main job” as finding good trading ideas, while investor B sees their main job as making wise decisions and maintaining a well-managed investment portfolio.
The difference in mentality here could greatly favor investor B. That is because, if investor A is overly focused on trading ideas, they will be prone to impatience and excessive activity, while possibly neglecting important portfolio areas like position sizing and risk management.
Investor B, on the other hand, will spend more of their time on the “main job” of making good decisions across the portfolio as a whole — and the time and energy it takes to do this could increase natural patience levels as they wait for the next strong trading idea. As with Wall Street analysts, fewer swings at fatter pitches could then improve results.
Investment software can help in at least two ways here: First, by making the “main job” of portfolio management easier; and second, by making it easier to find and evaluate high-quality trading ideas.
Improvement in these areas could be the difference between success or failure, or “decent” long-term results versus excellent long-term results for the individual investor.
TradeSmith Research Team