Which analysts to follow

A hedge fund manager once told me that macro data is free because you can’t make money with it. Instead, he was spending a lot of money on acquiring alternative data. Alternative data that provides insights not available by traditional fundamental analysis or macroeconomic data is big business these days. And this kind of alternative data can indeed create valuable insights that lead to better performance.

But why not pay for alternative insights in the form of analysts that are not as widely followed because they are working at independent research houses, smaller brokerage firms or are self-employed?

If you are a fund manager or a research analyst on the buy side your problem tends not to be that you don’t have enough information, but that you have too much. The same goes for access to analysts at investment banks. Here in Europe, MiFID II has led to the unbundling of research costs so fund managers and pension funds have to pay a fee to get access to research. The result is that many fund managers have cut their budgets and focused their payments on the large investment banks with many analysts and a broad coverage. But that means that fund managers are effectively all increasingly reading the same analysis from the same small number of firms. And because of this increasing focus in investor attention (plus obviously the rise of textual analysis by high frequency traders) share prices react differently to analyst recommendations today than they did a decade or two ago.

The chart below from an analysis by Pictet Asset Management shows that changes in analyst recommendations lead to stronger share price moves on the day of the publication but a smaller drift of share prices in the two months afterwards. Financial markets have become more efficient in incorporating new information into the share price.

Reaction of share price to analyst recommendation of a stock

Source: Pictet Asset Management

The problem for fund managers is that they cannot outperform by doing the same thing as everybody else does. By following the same analysts as most of the investors in a market, it has become more and more difficult to get an edge in terms of information or analysis. Fund managers have created their own little information bubble driven by the highly influential analysts at large brokerage firms. And this information bubble is further reinforced by financial media which tends to interview analysts from large brokerage firms rather than some lesser known outsider.

For the media that is fine because their job is to generate clicks not returns. But for fund managers living in this information bubble is dangerous. They risk investing based on analysis that is widely known and already incorporated in the share price of a company.

Instead, what fund managers and other investors should do is look for alternative sources of information. The trick, as the above-quoted analysis by Pictet shows, is to find analysts who are not widely followed but are reliable in their analysis and forecasts. When these analysts are making stock recommendations the share price doesn’t react as much as for mainstream analysts, but in the two months afterwards there is a stronger drift as the market slowly incorporates the insights of these analysts into the share price. This small initial share price reaction and an extended drift allows investors to outperform the market because if they are the ones who read the analysis of these lesser known analysts first, they can jump into stocks before the rest of  the market gets wind of a good idea.

Back in the day when I was managing portfolios, I was following the research of one major brokerage firm to get broad coverage across many stocks. Beyond that, I was spending my time mostly in following the reports and blogs of lesser known people with a specific expertise. And I think that helped me formulate differentiated views on stocks and markets that ultimately helped my performance. So, if you are a fund manager looking to become more selective in the research you read, stop spending so much money on the research of big brokerage firms and shift more money to smaller firms. They are the ones that are more likely to make you money than the big firms.