Paradoxical Returns: Why the Most Popular Stocks Often Make Poor Investments
Sep 12, 2024With the speed of information increasing exponentially over the past decades, it seems like Wall Street analysts’ stock recommendations hit the headlines daily. Investors often overreact to these reports, causing short-term, multi-billion-dollar swings in a company’s market value. While an analyst’s recommendation to buy a given company may be a positive development for the stock, it is important to call into question how accurate these recommendations are over extended time frames. Empirical evidence shows that lower (sell) ratings typically have better annualized returns than their beloved, highly rated counterparts.
While Wall Street analysts are undoubtedly intelligent and dedicate considerable time studying the companies they cover, their recommendations are not always disinterested. External factors can influence their reports, such as their employer’s banking relationship with a company, or the desire to boost trading activity and commissions. Additionally, analysts sometimes fall victim to a “herd mentality," and let prevailing market sentiment influence their recommendations rather than venturing into contrarian territory and risk their reputation if the call goes wrong. All too often we see analysts exhibiting emotional bias, loving stocks that are rising quickly and hating stocks that are falling fast.
As mouth-watering as a recommendation may be, back-testing suggests that “strong buy” ratings may not be an indication of strong future returns. Using Bloomberg, we performed a factor back-test that measured the returns of the S&P 500 separated into quintiles based on analyst recommendations. You will find the most popular, analyst loved and recommended stocks in the first quintile (Q1), and the most hated and neglected stocks in the last quintile (Q5).
Despite the adoring ratings from analysts, the first quintile (category Q1, stocks with the highest average favorable analyst ratings) had the lowest annual return, the highest volatility levels, and the largest drawdown compared to their less popular peers. The low average turnover percentage for the first and fifth quintiles indicates the often-static nature of these ratings; the most popular names typically maintain their high ratings, and companies that fall out of favor with analysts tend to remain there for a while. Although high turnover could have been attributed to the higher returns exhibited by the fourth quintile, the low turnover/higher return mix in the fifth quintile shows there are other elements at play in measuring return. Focusing on the Max Drawdown of each quintile, we see that Wall Street’s darlings have the largest drawdown compared to the other quintiles, with the fifth quintile having the smallest drawdown.
The data shows that “Buy” recommendations are not magic solutions to stock selection, but it is helpful to understand why. Reflecting upon elementary economics, this phenomenon traces back to supply and demand. If there is a stock where every Wall Street analyst is recommending its purchase, there is a point where the stock becomes over-owned. In other words, because most investors already own the stock for their portfolios, there is only a limited number of investors left to buy the stock and drive future gains. Alongside the idea that a highly recommended stock becomes over-owned is the risk that these stocks have violent declines if sentiment changes, and everyone rushes to sell the stock rapidly. We can see this effect play out in the data, with maximum drawdowns occurring in the first, most highly rated, quintile.
This data offers rich insights, and even deeper dives into individual securities within the quintiles can be revealing. The key takeaway of this paper though is that analysts’ positive recommendations should not heavily influence the decisions about which stocks go into portfolios. There are numerous reasons why these calls can fall flat. Black Swan events can expose flaws in analysts' models, economic forecasts can be spectacularly wrong, and conflicts of interest can create biases that distort judgments. Regardless of the cause, remember: a "Buy" rating should not be the sole driver of your investment decisions.
Managed Asset Portfolios Investment Team uses analyst reports to better understand industry trends, analyze alternative data, and gain additional insight from industry experts and company management. We do not rely on the recommendations or price targets of Wall Street analysts when making investment decisions. The Investment Team seeks out and invests in their best ideas from around the world, even if Wall Street has an opposing viewpoint. Analysts tend to re-rate stocks to “Buys” after positive catalysts have been realized, whereas we attempt to find those hidden catalysts and aim to be invested while those catalysts are materializing, not after. Since inception, the Investment Team’s differentiated, proactive approach has helped to achieve historically superior risk-adjusted returns.
Managed Asset Portfolios Investment Team
Michael Dzialo, Karen Culver, Peter Swan, Zachary Fellows, John Dalton, and Nicolas Vilotti
September 12, 2024
1The back-test methodology utilized Bloomberg’s Best Analyst Rating® to calculate standardized current average consensus analyst ratings for S&P 500 stocks that were placed into a scale distributed across five quintiles with Q1 (Strongest Buy) through Q5 (Strongest Sell), then the numerical rating was averaged, along with monthly rebalancing to properly reflect accurate Consensus Ratings. Performance of the S&P 500 is shown gross.
Certain statements may be forward-looking statements and projections which describe our strategies, goals, outlook, expectations, or projections. These statements are only predictions and involve known and unknown risks, uncertainties, and other factors that may cause actual results to differ materially from those expressed or implied by such forward-looking statements. The information contained herein represents our views as of the aforementioned date and does not represent a recommendation by us to buy or sell this security or any other financial instrument associated with it. Managed Asset Portfolios, our clients and our employees may buy, sell, or hold any or all of the securities mentioned. We are not obligated to provide an update if any of the figures or views presented change. Past performance is no guarantee of future results.
