Catching up with contrarians

In a previous post, I have shown that while most analysts herd in their forecasts (i.e. they imitate other analysts’ forecasts in order not to stand out from the crowd), there is a small but important minority of contrarian forecasts. It is worth heeding these contrarian forecasts, because they tend to be more accurate than herding forecasts and often the result of a more accurate assessment of a company’s fortunes.

An interesting study has examined how other analysts react to such contrarian forecasts. They use a different measure of contrarianism first introduced by Michael Clement and Senyo Tse. This measure – called analyst boldness – characterises a forecast as bold if it is both above the consensus of other analysts’ forecasts and above the analyst’s own prior forecast. Similarly, a bold negative forecast is one where the analyst is revising her previous forecast downward despite already being more pessimistic than consensus. Though not the same measure I showed previously, the research on bold forecasts shows that they are more accurate than other forecasts and have on average a forecast error that is five percentage points lower than other forecasts.

Because these bold forecasts tend to be more accurate, other analysts seem to pay attention to them as well. The chart below sorts companies based on the percentage of analysts who have made bold forecasts in the previous quarter. The more analysts have made such bold forecasts, the more likely it is that an analyst will make a bold forecast herself afterward. Of course, this pattern could be caused by a few analysts engaging in an escalating commitment to bold forecasts where most analysts stay close to the consensus and two or three analysts come up with ever more outrageous forecasts to get the attention of investors. However, a closer analysis of the data shows that this is not the case.

Peer group boldness and analyst forecasts

Source: Kumar et al. (2019).

What is going on here is that one or two analysts make a bold forecast and because these bold forecasts tend to be more accurate other analysts have to catch up with these bold (and typically contrarian) analysts with their own revisions. It is like a herd that tries to catch up with the leader after the leader has gone in a new direction.

Because the study of Clement and Tse also shows that bold forecasts are followed by bigger price swings in the share price this finding has some important implications for investors. First, it is important to track who is making the bold or contrarian forecasts and to scrutinise these forecasts carefully, because they tend to be more accurate. Second, once a bold forecast is made and an investor has come to agree with it, it is worth building positions in these stocks early, because the herd of analysts will gradually fall in line with this new assessment of the company, moving the share price in the direction of the original bold forecast.

Of course, that depends on the bold forecast being correct in the first place, which is not always the case. In fact, this situation reminds me of the task of selecting actively managed funds. We know there are some managers that beat their benchmark after fees, but they are a minority and most investors are unable to pick outperforming managers ex ante. Yet, some metrics can shift the odds in one’s favour. When it comes to assessing sell-side analyst recommendations, contrarianism and boldness seem to be just such metrics that can shift the odds of success.