AltaVista Research, a New York based ETF research firm, recently added analyst ratings to its analysis of ETF fundamentals. AltaVista found the consensus ratings to be like the children of Lake Wobegon[1] in that they are all above average.
Using data from Factset, AltaVista analyzed consensus ratings for more than 9,600 equities held by the ETFs they cover. Of those, 23.7% had the top rating of Buy while another 43.7% earned a rating of Overweight; 27.6% were rated Hold while just 4.1% were Underweight and 1.2% rated Sell. In other words, more than two-thirds of issues enjoy above-average ratings.
The problem grew more acute when the firm calculated a composite rating for each ETF. 807 ETFs had composite Overweight ratings and only 73 in the Hold range with none rated Underweight or Sell.
AltaVista still found that consensus recommendations appeared to have some predictive power, of a negative variety. While the average stock with a Buy recommendation gained 0.2% over the period, those with Overweight recommendations lost 2.1%, Hold recommendation lost 3.0% and the lowest tier gave up 5.7%. Over the same period, the market fell 1.8%.
As Michael Krause, head of AltaVista put it, “None of this is proof that analysts’ recommendations are the key to good investing. In fact, some of the academic literature suggests that they are, if anything, contrary indicators (in which case, they’d still be useful).”
AltaVista has added consensus ratings to the other fundamental ETF data they collect, such as sales, earnings, and dividends, among other financial metrics.
Our Take
There have been various theories to explain equity research’s optimistic bias. Regulators implementing the Global Research Analyst Settlement argued that investment banking fees encourage positive coverage of issuers and potential issuers. Retaliation from publicly traded companies is also a concern, as short ideas specialists know only too well. The market’s historical tendency to increase over long periods of time also supports overall bullishness.
AltaVista found higher consensus ratings have better performance than lower ratings, but this needs to be used with caution since the performance was largely negative. AltaVista’s analysis demonstrates why analyst recommendations are not highly valued by most institutional investors.
[1] Fictional town in Minnesota where “all the women are strong, all the men are good looking, and all the children are above average.” The Lake Wobegon Effect denotes people’s inherent tendency to overestimate their own abilities.