Analyst do not read across enough

A while back I wrote a post that discussed how analysts should read more into read-across from star companies in their sector. This information tends to be very informative for the sector overall and thus allows them to make better forecasts. Yet, in practice, many analysts ignore this information or underweight it in their assessments of a company. This seems to happen not just with the major star firms in a sector but also with other firms that are more peripheral.

A new research paper analysed the reaction of analysts to earnings news of US companies. The trick was not simply to look at the abnormal stock return around earnings announcements that are driven by positive or negative earnings surprises but to also take into account the coverage universe of each analyst covering the stock.

Hardly any analyst has the bandwidth to cover all the relevant stocks in her sector. Hence, they have to restrict their coverage universe. As you might have guessed, analysts cover the stocks in their coverage universe much more closely than stocks that are economically similar but not in their coverage. And guess what, if a stock in their coverage universe has a positive or negative earnings surprise, they adjust their forecasts and recommendations for the stock.

Because analysts on average overreact to news, they overshoot with their revisions and create an abnormally high share price reaction immediately after the news is released that then reverses at a later stage. The chart below shows that these abnormal returns tend to be small but measurable.

Share price abnormal returns around earnings announcements (EA)

Source: de Haan et al. (2024)

However, if a company the analyst doesn’t cover publishes earnings, they do not change their recommendations for companies under coverage. The more analysts cover a stock, the more the stock will overreact to earnings news, and lesser covered stocks will see less of a share price reaction because fewer analysts revise their earnings.

This opens up the possibility of creating an arbitrage strategy where one shorts the stocks with high coverage and buys stocks with low coverage shortly after an earnings announcement. Such an arbitrage strategy does deliver an average monthly return of 1.2% but that is before transaction costs and it requires an investor to be able to short some stocks and buy other stocks at almost an instant’s notice. So not something you and I can do and even many hedge funds would struggle with this. But while it isn’t something that can be arbitraged away with a long-short investment strategy, it still shows that companies that are glamor stocks and covered by more analysts are prone to share price overreaction to earnings news.

And if you think that has anything to do with the share price reaction of Magnificent 7 stocks around every one of their earnings announcements and that you can expect a much stronger share price reversal after the initial reaction to an earnings release, you might be up to something.