do european brokers add any value through recommendations · pdf filedo european brokers add...

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DO EUROPEAN BROKERS ADD ANY VALUE THROUGH RECOMMENDATIONS?A fund manager’s perspective by Campbell Harvey (PhD), Sandy Rattray, Joachim Utans (PhD) and Yasser Mawji

September 2009

Fund managers are consumers of broker recommendations. In this note, we look at whether these recommendations add value in Europe. There’s been little published research on this topic, and most of it pre-dates the regulatory changes of 2003/4.

Our analysis suggests that European brokers’ recommendations outperform during 2005-2009. Trade ideas from research sales-people, the people in daily contact with fund managers, provide better performance than recommendations directly from research departments. Our results also demonstrate that brokers are far better at selecting long ideas than short ideas, and have been for many years.

We also show that a simple strategy based on broker ideas would comfortably be in the top quartile of UK pan-European mutual funds for each complete year for which we have data.

MARKET OPINIONS OF ANALYSTSThere is considerable disagreement about the value of analyst recommendations. Some fund managers dismiss research as having little value to add. The academic research is split as to whether analysts add value. Regulators apparently believe analysts are important (and so need to be regulated).

Anecdotal fund manager criticism of analysts is often coloured by recollection of a particularly strong or weak recommendation. Fund managers often view analysts as good sources of information about companies. In general, however, fund managers do not rate analysts as stock pickers. A second, typical, criticism is that ‘brokers are quite momentum driven’. Fund managers are obviously the closest professional group to research analysts, so their criticisms should be taken seriously.

The message from the academic research is mixed. A possible reason is that there are many different choices that need to be made in evaluating analysts. Some research has considered direct recommendations (which are infrequent), while other research looks at earnings estimates (which are frequent). Some work focuses on different style categories, while others vary across geographies as well as industries. Given the recent regulatory changes, the years chosen for analysis can also lead to substantially different results.

Many of academic papers show that while there is some excess return from broker recommendations, most of this is absorbed by transaction costs. We have summarised the most cited and recent papers in Appendix 1.

Regulators have not made an issue as to whether broker research is effective, but they have strongly stated that research needs to be impartial1. Given the significant regulatory changes, we believe that there is little point looking at broker recommendations prior to 2004.

BUYS VS. SELLS: NOT TWO SIDES OF THE SAME COINBuy recommendations and sell recommendations are very different:

• The fund manager, as a consumer of recommendations, has a greater demand for buy recommendations. The reason is simple. Most managers are long-only managers. Of course, there is some demand for short ideas. The long-only manager may use these recommendations to underweight names if they are very benchmark focussed. Sell recommendations are useful to managers with short or long-short mandates. Nevertheless, the demand side is quite long-biased given the dominance of long-only investors. So it makes sense that brokers would put less time into sell than buy recommendations.

• Obviously, companies prefer good news from the analysts that cover them. While there are many rules in place to require them to treat all analysts equally, it is inevitable that they will find dealing with positive analysts easier than negative analysts. (How many of us really find negative feedback easier than positive feedback?)

• The downside of being incorrect is greater with sell recommendations. A stock with a sell recommendation can go up by an unlimited amount (unlimited potential error), while a stock with a buy recommendation can only fall by a limited amount (limited potential error).

These three factors suggest that at the very least an analyst should issue a new sell recommendation with more caution than a buy recommendation.

This is the first in a series of articles we will publish on broker recommendations which we hope will be useful to investors.

1. The US Global Analyst Research Settlement of April 2003, the EU Market Abuse Directive of 2003, the EU’s Markets in Financials Instruments Directive of 2004 (MiFID) and the FSA’s rules stemming from CP205 and implemented in July 2004 all targeted analyst conflicts of interest and the fairness of research.

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DO EUROPEAN BROKERS ADD ANY VALUE THROUGH RECOMMENDATIONS? I SEPTEMBER 2009

2. We have defi ned a ‘buy’ as recommendations that IBES has termed 1 (strong buy) or 2 (buy) and where the recommendation is more positive than previously for the analyst. 3. IBES takes one or two days typically to incorporate the idea into their database, so investors relying on IBES will be delayed compared to investors who receive research directly from the broker. We are using the day IBES says the recommendation is made (‘announcement date’), as opposed to when IBES actually delivers that information.

PERFORMANCE OF BUY RECOMMENDATIONSIn Exhibit 1 we show the performance of European buy recommendations, as reported by the IBES database2. We have shown excess performance to the market, using the DJ STOXX Large, Mid or Small cap index depending on the market cap of the stock. Performance is set at zero on the close of the day the recommendation is made3. We have shown performance from 60 days prior to the recommendation out to 100 days after. Each line represents recommendations made in a particular year. We use STOXX 600 constituents only for this analysis. There are no adjustments for transaction costs.

Exhibit 1: Performance of European buy recommendations relative to market by year

2.50%

2.00%

1.50%

1.00%

0.50%

0.00%

-0.50%

-1.00%

-1.50%

Trading Days-60 -40 -20 0 20 40 60 80 100

Cum

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Exc

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Ret

urns

2005 (19.6% of ideas)2006 (24.4% of ideas)2007 (29.0% of ideas)2008 (26.9% of ideas)

In all four years, the average buy recommendation was either moving in line with the market or underperforming prior to the recommendation change. So there’s relatively little evidence to suggest that analysts are ‘momentum chasing’ by putting buy recommendations on outperforming stocks.

One notable feature is the run up in return just before we implement the recommendation. There are several possible causes for this. First, we implement the ideas at the close of the day the recommendation is issued. If the idea is issued in the morning, the stock could rise during the day before we implement our long position. Second, it is possible that the analysts don’t immediately give their ideas to IBES. Third, analysts can often issue recommendations shortly after other analysts, which means that the later analysts recommendations performance is infl uenced by others. Fourth, buy recommendations may follow a positive event (good results, for example). All of these factors likely account for the run-up just before time 0.

SELL RECOMMENDATIONSSell recommendations are much less consistent than buys. There are also about half as many sell recommendations as buys made by brokers.

There are a number of similarities to the analysis of buy recommendations. Analysts generally (except 2008) put sell recommendations on outperforming stocks (anti-momentum). On average stocks stop outperforming at that point, but they only underperform signifi cantly in two years, 2007 and 2008.

Buy recommendations showed positive average returns in every year of the evaluation period.

Exhibit 2: Performance of European sell recommendations relative to market by year

Trading Days

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Exc

ess

Ret

urns

-60 -40 -20 0 20 40 60 80 100

4.00%

3.00%

2.00%

1.00%

0.00%

-1.00%

-2.00%


Exhibit 3: Performance of European buy and sell recommendations relative to market during fi rst six months of 2009

Trading Days

Cum

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ive

Exc

ess

Ret

urns

-60 -50 -40 -30 -20 -10 0 10 20 30 40 50

8.00%

6.00%

4.00%

2.00%

0.00%

-2.00%

-4.00%

-6.00%

-8.00%

Buys (55.8% of ideas)Sells (44.2% of ideas)

EXTREME MOVES IN 2009Our early data suggests that 2009 has been an extreme year for analyst performance. Buy recommendations have worked very well, sell recommendations very poorly. Exhibit 3 shows performance for recommendations made in the fi rst half of 2009. Brokers also made more sell recommendations than usual in 2009.

THE RESEARCH SALESPERSON – MORE THAN JUST A MOUTHPIECEAt GLG Partners we collect ideas given to us by a select group of brokers in real time. We only allow one individual per broker to contribute and insist on two to three month horizon ideas with a fundamental (as opposed to technical) reasoning. The contributors are highly experienced research salespeople.

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SEPTEMBER 2009 I DO EUROPEAN BROKERS ADD ANY VALUE THROUGH RECOMMENDATIONS?

We spend considerable effort selecting the research salespeople that contribute ideas to us. We look for contributors who have a strong research department behind them. We have both contributors who focus pan-Europe as well as those that focus on specifi c countries. The contributors are required to give research driven ideas, which typically means that they have discussed them with their own analysts before submitting them. It may also mean that they select only the best ideas from their analysts. Because we allow brokers to only select one person to present ideas to us, and because we are a large client of these fi rms, we tend to have a senior research salesperson contributing to us.

The role of a research salesperson is to collect research from his or her fi rm’s various research groups, digest it and then select individual ideas to present to clients, perhaps with their own interpretation. A cynic might argue that they simply repeat recommendations from the research department with no added value. An alternative view is that the experienced research salesperson knows how to select the best ideas from their fi rm and put them in touch with the appropriate fund managers or analysts at clients.

Exhibit 4: Performance of European buy ideas relative to market by year from GLG trade ideas database

2.00%

1.50%

1.00%

0.50%

0.00%

-0.50%

-1.00%

-1.50%

-2.00%

Trading Days

Cum

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ive

Exc

ess

Ret

urns

-60 -40 -20 0 20 40 60 80 100


Exhibit 5: Performance of European sell ideas relative to market from GLG trade ideas database

2.00%

1.50%

1.00%

0.50%

0.00%

-0.50%

-1.00%

-1.50%

-2.00%

Trading Days

Cum

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Exc

ess

Ret

urns

-60 -40 -20 0 20 40 60 80 100


Careful comparison of these return profi les with the IBES database results shows the value added by the research salespeople. While the performance of research salespeople is clearly strongly affected by the performance of the broader research function, they outperform the broader universe of all analyst ideas. For buy ideas, each year shows an excess return of greater than 1.1% after 100 days.

The performance of sell ideas is somewhat mixed (like the analyst universe). There is no excess performance in 2006 like the analyst universe. The short strategy lost some money in 2008.

Our universe of research salespeople is our own selection, but assuming that our grouping is representative, then our evidence suggests that good research salespeople do indeed add value both through good selection of ideas from their own research departments and good ideas of their own.

Clearly when we build portfolios using the recommendations we receive, understanding the performance of buys and sells as well as the interactions between brokers is tremendously important.

ARE THESE MOVES LARGE ENOUGH TO BE USEFUL?We think they are. Imagine a simple long-only fund management strategy which reacts to all broker recommendations. The strategy buys at the closing price on the day the recommendation is received and exits 65 days later. Using the GLG trade ideas database average returns would exceed market returns by 0.80% – 1.69%, which we could achieve four times a year (260 trading days/65 day holding period = 4x). Assuming commissions of 5bps each way, and trading at closing prices on the day of idea receipt, then returns would lie in the range 2.8% – 6.4% in excess of benchmark (clearly trading when ideas are received rather than waiting until the close will be advantageous to the strategy). This is enough to place the strategy in the top quartile of UK mutual funds with a Europe including UK benchmark in all four years. This simple strategy involves implementing all recommendations over a fi xed holding period for each idea. Obviously, there are numerous execution improvements that could be made. Our calculation of 2.8% to 6.4% is meant to be illustrative of the opportunities available for the simplest investment strategy.

APPENDIX 1: SUMMARY OF ACADEMIC WORK The academic literature on the role and impact of equity analysts is vast. We highlight a few representative academic papers discussing the value of analyst recommendations. In general, papers conclude that while there is value in recommendations, it is diffi cult to exploit after transaction costs. For example, Womak4 fi nds short term excess returns as well as longer term post recommendation drift. Barber, Lehavy, McNichols and Trueman5 describe a trading strategy that exploits changes in

4. Womack, K. ‘Do brokerage analysts recommendations have investment value?’ Journal of Finance, 51, 137-167 (1996). 5. Barber, B., R. Lehavy, M. NcNichols, B. Trueman. ‘Can investors profi t from the prophets? Security analyst recommendations and stock returns.’ Journal of Finance, 56, 531-563 (2001).

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DO EUROPEAN BROKERS ADD ANY VALUE THROUGH RECOMMENDATIONS? I SEPTEMBER 2009

6. Jegadeesh, N., Kim, J., Krische, S. D., Lee, C. ‘Analyzing the Analysts: When Do Recommendations Add Value?’ Journal of Finance, 59, 1083–1124 (2004). 7. Mikhail, M.B., B.R. Walther, R.H Willis. ‘Do security analysts exhibit persistent differences in stock picking ability?’ Journal of Financial Economics, 74, 67-91 (2004). 8. Jegadeesh, N., Kim, W. ‘Value of analyst recommendations: International evidence.’ J. Financ. Mark. 9,. 274–309 (2006).

Important Information

This information is communicated and/or distributed by the relevant AHL or Man entity identifi ed below (collectively the ‘Company’) subject to the following conditions and restriction in their respective jurisdictions.Opinions expressed are those of the author and may not be shared by all personnel of Man Group plc (‘Man’). These opinions are subject to change without notice, are for information purposes only and do not constitute an offer or invitation to make an investment in any fi nancial instrument or in any product to which the Company and/or its affi liates provides investment advisory or any other fi nancial services. Any organisations, fi nancial instrument or products described in this material are mentioned for reference purposes only which should not be considered a recommendation for their purchase or sale. Neither the Company nor the authors shall be liable to any person for any action taken on the basis of the information provided. Some statements contained in this material concerning goals, strategies, outlook or other non-historical matters may be forward-looking statements and are based on current indicators and expectations. These forward-looking statements speak only as of the date on which they are made, and the Company undertakes no obligation to update or revise any forward-looking statements. These forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those contained in the statements. The Company and/or its affi liates may or may not have a position in any fi nancial instrument mentioned and may or may not be actively trading in any such securities. This material is proprietary information of the Company and its affi liates and may not be reproduced or otherwise disseminated in whole or in part without prior written consent from the Company. The Company believes the content to be accurate. However accuracy is not warranted or guaranteed. The Company does not assume any liability in the case of incorrectly reported or incomplete information. Unless stated otherwise all information is provided by the Company. Past performance is not indicative of future results.Unless stated otherwise this information is communicated by Man Investments Limited and AHL Partners LLP which are both registered in England and Wales at Riverbank House, 2 Swan Lane, London, EC4R 3AD. Both are authorised and regulated in the UK by the Financial Conduct Authority.Australia: To the extent this material is distributed in Australia it is communicated by Man Investments Australia Limited, which is regulated by the Australian Securities & Investments Commission (ASIC). Germany: To the extent this material is distributed in Germany, the distributing entity is Man (Europe) AG, which is authorised and regulated by the Lichtenstein Financial Market Authority (FMA).Hong Kong: To the extent this material is distributed in Hong Kong, this material is communicated by Man Investments (Hong Kong) Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong. This material can only be communicated to intermediaries, and professional clients who are within one of the professional investor exemptions contained in the Securities and Futures Ordinance and must not be relied upon by any other person(s). Singapore: To the extent this material is distributed in Singapore, it is for information purposes only and does not constitute any investment advice or research of any kind. This material can only be communicated to Institutional investors (as defi ned in Section 4A of the Securities and Futures Act, Chapter 289) and distributors/intermediaries and should not be relied upon by any other person(s).Switzerland: To the extent this material is distributed in Switzerland, this material is communicated by Man Investments AG, which is regulated by the Swiss Financial Market Authority FINMA.UK/14/0586-P

recommendation consensus that is profi table before transaction costs, but returns after taking into account costs are insignifi cant. Jegadeesh, Kim, Krische and Lee6 document that these returns are primarily attributable to changes in recommendations, not the level. They also fi nd that recommendation changes are concentrated on glamour stocks (positive momentum, high growth, high volume, relatively expensive).

One branch of the literature studies the characteristics of analysts and their sell-side environment. A typical question is whether differences in analysts stock picking ability is persistent. Mikhail, Walter and Wills7 fi nd that this is indeed the case, and that the market recognizes this. Stock recommendations by analysts who have outperformed over a longer period have larger post recommendation excess returns.

Almost all academic research on this subject analyzes analyst recommendation for US stocks. Jegadeesh and Kim8 compare the characteristics of analyst recommendations in the G7 countries. There are broad similarities, for example, the number of buy recommendations exceeds the number of sell recommendations by a large margin. They report that prices react signifi cantly to recommendation changes, with the strongest price response in the US and Japan, and a smaller response in the UK, Canada, France and Germany. They show that a trading strategy is profi table before transaction costs in all countries except Italy, and works best in the US.

APPENDIX 2: EARNINGS REVISIONSAnalysts revise earnings estimates much more often than they revise recommendations. A positive earnings estimate revision is therefore a weaker statement than a buy or strong buy recommendation, but our sample is much larger. Consistent with this, it appears that the performance impact of earnings revisions is consistently lower than for recommendations. There is also a much stronger momentum component here (i.e positive revisions to outperforming stocks and vice-versa).

Exhibit 6: Performance of European positive earnings revisions relative to market by year

Trading Days

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1.00%

0.00%

-1.00%

-2.00%

-3.00%

-4.00%-60 -40 -20 0 20 40 60 80 100


Exhibit 7: Performance of European negative earnings revisions relative to market by year

6.00%

5.00%

4.00%

3.00%

2.00%

1.00%

0.00%

-1.00%

-2.00%

Trading Days-60 -40 -20 0 20 40 60 80 100

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