In my last post, I indicated that investors should normally not compete against professionals.

That does not mean you cannot rely on their skills in an attempt to enhance your own portfolio returns. In fact, many investors follow analyst recommendations and invest in mutual funds that are actively managed.

Whether this is a prudent investment approach is something we will look at.

As in all walks of life, some analysts and fund managers have better track records than others. If you intend to rely on their advice or investment decisions, you should try to find the ones with proven track records.

Mutual Fund Managers

We covered the key areas of consideration in a couple of previous posts.

Please review Mutual Fund Management for suggestions on assessing fund management.

To try and separate the upper tier managers from the lower tier, I suggest using the recommendations contained in Fund Performance is a Relative Concept.

Keep in mind that past performance is no guarantee of future results. A manager’s prior results may be suggestive of the future, but many other variables can impact the actual results.

Investment Analysts

Assessing an investment or research analyst is quite similar to evaluating a mutual fund manager.

As in Mutual Fund Management, you want to know a little about the analyst you are interested in following.

How long a history does she have as an analyst? What are her technical credentials? Does she have experience in her area of research? For example, the analyst may have 10 years of experience analyzing European bonds. This may be good if she is still rating bonds. But it may not be a good sign if she is now analyzing Australian mining companies.

How has the analyst has performed in both bull and bear markets? When the markets are up, it is relatively simple to see one’s picks rise in value. But how did she do when the market as a whole fell? That may tell a different story.

You might also want to know the analyst’s financial interest in the recommendation. This can be a two-edged sword though. On the one side, it is nice to see the analyst own the securities she recommends and is putting her own money into the investment. On the other side, perhaps there is a conflict of interest if the analyst has a financial stake in the investment. That is, maybe the security is being recommended in the hopes that individuals will read the positive review, put their own money into the security, thereby driving up the price and enhancing profits for the analyst.

And exactly like in Fund Performance is a Relative Concept, how did the analyst perform compared to her peers and any identified benchmarks?

Note that there may not be any associated benchmarks with selections of individual securities. However, that does not mean you cannot create your own as an assessment tool.

I would suggest something simple. For example, if the analyst is rating Swiss equities, the Swiss Market Index (SMI) might be adequate. The SMI holds the 20 largest stocks in the Swiss equity market.

Or you could use a number of other Swiss indices depending on your investment criteria. The SMI Mid (SMIM) that holds the 30 largest Swiss mid-cap equity stocks not included in the SMI. The SMI Expanded includes the 50 stocks that comprise the SMI and SMIM. And the Swiss Performance Index is Switzerland’s overall stock market index. And that is only a few indices from Switzerland. There are others you can use based on your needs.

Do Investment Analysts Provide Positive Returns?

We will consider the active versus passive management debate concerning mutual funds in a separate post.

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 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 if 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. In part, this is why 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 there estimates. In fact, there is evidence to suggest that analysts are indeed too optimistic.

For example, in April of 2010, McKinsey Quarterly (registration required) wrote that “Equity Analysts: Still too bullish”. The authors found that:

“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.

For example, The Wall Street Journal issues an annual list of The Master Stock PickersThe lists rank the top stock pickers in 44 different industries based on the analyst’s recommendation and subsequent performance. So there are a lot of different industries that have unique analysts.

For 2008, the number one analyst in each of the 44 industries is named (you can also access the top 5 in each category if you subscribe to The Wall Street Journal). A pretty impressive group. Then I compared that list to 2009, which provides the top 5 analysts in each of the same 44 industries.

Of the 44 winners in 2008, only 5 of the 44 make the list of 220 named analysts for 2009. And of the 5, there was only 1 repeat winner. The remainder were ranked 3rd (1) or 4th (3) in their industries for 2009.

The change in the top ranked analysts is significant from 2008 to 2009. Where will they be in 2010?

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 look at the passive versus active management debate. Also known as, can fund managers beat their benchmarks?

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