Both Yahoo! Finance and the British Telegraph noted this week that for the first time in more than two decades (before the introduction of the iMac and iPod) five financial analysts rate Apple’s stock as a “sell.” All five downgrades to “sell” came this year, and they all relate to concerns about the iPhone line sales, particularly in China.
This is far from a stampede. Of Apple’s analysts tracked by Bloomberg, 23 still rate the stock a “buy” and 21 recommend “hold.” But with the five “sell” recommendations, Apple’s average (consensus) recommendation is now slightly below “hold,” for the first time in many years. Should this be of concern to Apple’s shareholders? Apparently not, since Apple’s share price rose by more than 40% this year, from the low of January.
So what do analysts’ recommendations mean to investors? Anything?
Skepticism about financial analysts is widespread particularly since the 2000 tech bubble burst. Several studies have revealed systemic biases in analysts’ earnings forecasts and stock recommendations. For example, some sell-side analysts working for large investment banks were found to issue more positive forecasts and recommendations for stocks underwritten by their houses. And overall, “sell” recommendations are very rare: about 5-7% of all stock recommendations. Apparently, concerned with pushback from corporate executives, and being denied access, analysts are reluctant to antagonize managers with a negative recommendation.
I expressed several times a more substantive concern with analysts’ work product: they still relay heavily (though not exclusively) on corporate financial reports, and earnings, in particular, which I have shown lost much of their relevance to investors (see, for example, “Time to change Your Investment Model,” Financial Analysts Journal, September 2017).
So, should investors pay attention to analysts’ stock recommendation? Let’s look at the evidence.
Barber et al., 2001 (“Can investors profit from the prophets?, Journal of Finance) examined investors’ gains from following analyst stock recommendations, and concluded that the most highly recommended stocks outperform considerably the least favorably recommended stocks, by 102 basis points per month. Such gains, however, require frequent trading, and much of the gain is “eaten up” by transaction costs.
Jegadeesh et al., 2004 (“Analyzing the analysts…,” Journal of Finance) examined comprehensively analysts stock recommendations (buy, hold, sell) and concluded that the quarterly change in the consensus recommendation “is a robust [stock] return predictor that appears to contain information orthogonal [independent of] a large range of other predictive variables.” For each sample firm, the researchers assigned numerical values to the recommendations of the analysts following the firm: 5 for buy, 3 for hold, and 1 for sell. The average number, say 3.25, is the consensus recommendation. These quarterly consensus changes, which each investor can easily compute, were found to be predictors of future stock performance: upgraded stocks significantly outperformed downgraded stocks.
Of particular interest to my international readers is the Jegadeesh and Kim 2006 study (“Value of analysts recommendations: International evidence,” Journal of Financial Markets). The researchers examined analysts recommendations in the Group of Seven (G7) countries. They report that in all countries “sell” recommendations are very rare, but the frequency is lowest in the U.S. However, the researchers report, based on results from trading on the recommendations, that “U.S. analysts add the most value.” Apparently, say the researchers “U.S. analysts are more skilled than the analysts in other developed countries in identifying mispriced stocks… Most likely, the higher compensation that the analysts in the U.S. receive attracts more skilled analysts.” I am not sure about that. My guess is that U.S. analysts have more incentives to quickly update their recommendations than analysts in other countries, with less active capital markets.
Back to Apple. The evidence indicates that changes in stock recommendations, like downgrades, are predictive of future stock performance. Perhaps investors should follow more closely the changes in Apple’s stock recommendations.