New York – We have discussed the Wall Street Journal/Thomson Analyst review already this week, but we feel there are a few other points to make. Of interest is the actual set up and measurement of the analysts' returns. We view the process to be somewhat lacking, biased and incomplete.
First, as our Monday blog indicated, the analytical homerun hitters are generally rewarded by the way performance is calculated. If the analysts makes one call that adds 200% over the period, his performance would be stellar, but we question whether it may have been simply lucky. With a greater amount of data, we could assess the probability of the calls being lucky.
Second, the analysis has no bogey. In other words, there is no way to know if the winner in a particular industry beat his own industry or not. Of course, chances are that he/she did, but this should be explicit rather than implicit via comparing the analysts' returns with the returns of a passive buy and hold portfolio of the analyst's stock over the same time frame.
Third, raw performance does not account for the analyst's ability allocate stocks into the correct category. This can be estimated by looking at the percentage of stocks that the analyst got in the right bucket (batting average). For example, the analysts had and average return of 30%, but had only 3 of 30 stocks he called Buys that actually increased in value. He would then have a but batting average of 10%.
Fourth, the analysts are allowed to have the announcement effect by virtue of getting the previous day's closing price when they make recommendation changes. This means that the analysts of the Bulge bracket firms can benefit from announcing the sell and watching it move south in response to their own call. Also the analyst can game the system by changing recommendations during the next day of trading to take advantage of any news that may have hit the markets that day and booking the change in price from the previous day's close as part of their own performance.
Fifth, there is no analysis of the amount risk the analyst has taken on board to achieve the returns posted. This risk can be take the form of market risk and default risk. There are well documented ways to test for the risk/return of a portfolio, including the Sharpe Ratio and the Information Ratio. Additionally, one could calculate the semi-variance of the portfolio – i.e. the risk of the stock falling, given a buy recommendation, or the risk of a stock rising, given a sell recommendation.
The obvious benefits of the Wall Street Journal /Thomson analyst assessment is its longevity and the consistency with which it has been calculated over the years. However, the performance could be augmented by adding some of the missing elements mentioned above.
Posted at 11:26 am by Thomas Hutchinson
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