Let’s be honest here for a minute. We know that sell-side analyst recommendations on average are not very helpful – an observation that is supported by hundreds of studies. But given this miserable track record, it is all the more important for portfolio managers to understand, which analysts to listen to and which not. In the age of MiFID II when the buy side has to pay for sell-side research, it is no wonder that many asset managers are cutting ties with analysts and brokers that they believe do not offer enough insight to be worth the fee. Thus, it becomes more important for portfolio managers to understand when sell-side analysts add value and when they don’t.
There have been several studies that looked at analyst behaviour as a group and found that many analysts herd in the sense that they anchor their forecasts on the consensus of other analysts’ forecasts. But there is a significant minority of analysts who avoid the herd and issue contrarian forecasts and these seem to be the ones that are worth listening to.
A study of 396,188 analyst reports between 2005 and 2010 looked at the instances when a company beat an analyst’s expectation or when an analyst revised her forecasts. As you might imagine, when a company beats the forecast, most analysts report on this as a positive event and become more optimistic about the company’s prospects. Similarly, when an analyst increases her earnings forecasts it is generally accompanied by an optimistic assessment. However, there are instances of negative contrarianism when a company beats the analyst’s forecast or an analyst upgrades the forecast earnings, yet remains pessimistic about the outlook for the company.
Similarly, there are instances of positive contrarianism, when an analyst remains optimistic about a company’s outlook despite the most recent earnings missing estimates or the analyst downgrading her earnings forecast.
Admittedly, these instances of positive or negative contrarianism are rare but not too rare. They happen in about 15% of all cases when a company beats or misses an analyst’s forecast and in about 10% of all cases when an analyst revises her forecasts.
Instances of analyst contrarianism
Source: Bozanic et al. (2019).
There are three possible reasons why analysts would make such contrarian calls:
They are stubborn, ignore the new information from the company reports, and just keep their recommendation no matter what.
They could discount short-term performance and expect the company to reverse its fortunes in the medium to long term.
They could be career oriented and try to stand out of the crowd to garner more broker votes and improve their chances to be hired for a better-paid job.
The study finds that analysts who are more accurate and more experienced are more likely to make contrarian calls. Furthermore, analysts who work at smaller, less prestigious firms are more likely to make contrarian calls. They do this because if you work at a smaller firm, you have a harder time gaining the attention of the buy side and there is nothing better to attract attention to your work than a contrarian call.
The situation is similar to the one of portfolio managers on the buy side. As I show in my book, funds managed by smaller boutique firms on average are more active and have better performance than funds managed by the large fund managers of this world. This is so because, at the large prestigious firms, analysts and fund managers alike have to consider career risk. If they make a contrarian call and it goes wrong, they will likely lose their job, but if they make a contrarian call and it proves correct, they have virtually no upside. So why bother with contrarian calls in the first place?
Of course, it would be stupid for an analyst to make a contrarian call just for the sake of being contrarian. Instead, analysts tend to make contrarian calls only when they have private information and are sure it will turn out ok. And the actual performance of the stocks on which contrarian calls are made seems to confirm this.
The chart below shows the return of stocks in the twelve months after a contrarian call is made relative to the return of the same stock when an analyst does not make a contrarian call. Investors should pay particular attention to negative contrarian calls because they tend to be followed by significantly worse performance than at times when an analyst stays within the herd. In cases of positive contrarianism the picture is somewhat more mixed, though. The average performance of stocks is better when an analyst downgrades her earnings forecast but remains optimistic about the company but there is no difference to other analysts’ performance when she stays optimistic despite the company missing her forecasts.
12-month stock returns after a contrarian call
Source: Bozanic et al. (2019). Note: The chart does not show the absolute performance of shares in the twelve months after a contrarian forecast is made but the relative performance of stocks after a contrarian forecast compared to times when no contrarian forecast is made.