Abstract
“This thesis investigates the economic value of stock recommendations retrieving data from a Spanish financial newspaper. Previous research in the Spanish market has shown that at least in the short-run there are some abnormal returns, however, in the long-run disagreement remains amongst academia. The purpose of this research is to examine the impact of analysts’ recommendations on Spanish stock returns and as to whether these stock recommendations can be potentially used for profitable investment strategies. Tested in the Spanish market between 2010-2017. The main findings of this paper suggest that following analysts’ recommendations don’t add any value, however, doing opposite could generate profitable investment strategies.”
Keywords: Analysts recommendations, Stock markets, Abnormal returns, Sell-side analysts, recommendation revisions, price drift
1. Introduction
For decades, recommendations based on fundamental analysis from security analysts have provided the financial markets with information (e.g. reports) which reflect the analysts’ opinions about the future prospects of specific companies. In modern financial markets, analyst research is essential to the production and dissemination of information. By issuing recommendations, analysts transfer the information to the investment community and improve the efficiency of the market. These recommendations generally range from strong sell to strong buy. However, in this study they have been clustered in Buy (1), Hold (2) and Sell (3).
We can easily distinguish between three main types of analysts: sell-side analysts (focus of this study), buy-side analysts and unaffiliated analysts. Sell-side analysts publish research on public companies. They provide their ideas to buy-side analysts, portfolio managers, and money management companies by talking to the management of the companies, following trends in the industry and making the recommendations on the stocks. Sell-side analysts works for brokerage firms. A buy-side analyst performs industry research, talks to the companies' management teams, provides earnings estimates, does valuation analysis and rates the stock prices of the companies, as ‘sells’ or ‘buys’. Buy-side research is not published but a buy-side analyst has to convince portfolio managers in the company to follow his recommendations. Buy-side analysts work for institutional money firms like mutual funds, pension funds and hedge funds. Lastly, unaffiliated analysts are not associated with institutional money firms or brokerage firms. Independent analysts often sell their recommendation reports to clients on a subscription or other basis. These recommendations help investors to make decisions so as to sell or buy stocks and securities, which is beneficially for the brokerage firm because they receive a commission on each transaction the clients make.
A study conducted by Chen & Cheng (2006), manifest that institutional investors do indeed trade at the time of sell-side analyst stock recommendations and that such strategies increase the profitability of their investments. But how do sell-side analysts issue their recommendations? Bradshaw (2004) document four different valuations models and examine the mechanisms by which analysts transform earnings forecasts into stock recommendations. A more sophisticated method called residual income valuations and as an alternative to these a simpler way, two valuation heuristics. Bradshaw (2002) examines a small sample of analyst research reports and finds that analysts rarely provide valuations obtained from the residual income or dividend discount models (sophisticated methods). One would expect that an analyst would use more sophisticated valuation models. However, Bradshaw (2004) noticed that the consensus recommendations of sell-side analysts are not consistent with the firm value that is derived when sophisticated models are used, such as the residual income model and the discounted cash flow model. In fact, the recommendations are more consistent with heuristic valuation models. Since Analysts do not use present value models alone as basis for their recommendations, the added value from analysts’ recommendations must lie in additional information not accounted for in present value models (e.g. quality of management, customer loyalty, etc.) Bradshaw (2004) found out that analysts’ recommendations do not appear to be useful signals for buy-and-hold investors. He also states that “perhaps analysts use such models, but personal opinions or biases dominate their recommendations” (Bradshaw, 2004: 47).
A question that immediately emerges is the potential conflict between the efficient market hypothesis and analyst recommendations performance. The Academia is still divided in its opinion whether following analysts' advice is valuable for investors after accounting for transaction costs. According to the Efficient Market Hypothesis (EMH) (Fama, 1970), sell-side analysts would not be able to add any value since any information they have should already be incorporated in market prices. Outperforming the market through investing in stocks that are selected by 'experts' or market timing should not be possible. In a fully efficient market, no price effect should be observed because the information was already available to a certain number of investors. However, Grossman and Stiglitz (1980) state that when there are costs associated to the collection of information, significant returns should be earned by those investors to compensate for bringing information to the market.
The US market seems to be the most used sample when conducting the research of security recommendations, while the data aimed on Europe is relatively scarce. Jegadeesh and Kim (2006) researched the Group of Seven (G7) countries, including some European countries and Azzi, Bird, Ghiringhelli and Rossi (2006) investigated analyst recommendations in fifteen European Countries, including Spain. Numerous studies can be found dealing with the effect of the short-term and long-term event studies and its impact on stock price after the publication of recommendations. First, Stickel (1995), showed that upgrades (downgrades) were correlated with positive (negative) abnormal returns. In addition, some studies pointed out that the market reaction to analysts’ recommendations (Womack, 1996) and target prices (Brav & Lehavy, 2003) could last several months. Barber et al. (2001) broaden the investigation to consensus recommendations, showing the possibility to earn higher returns by buying the most highly recommended stocks and short selling the least favourably recommended stocks. Following also a portfolio strategy, Jegadeesh et al. (2004) show that recommendation changes were a better predictor of future stock returns than recommendation levels, whereas Altinkiliç et al. (2016) using newer data set new evidence that analyst recommendations do not seem to have long-term investment value anymore.
In a similar way, in the Spanish market, four main papers related to the impact of sell-side analysts’ recommendations are standing out. Gonzalo & Inurrieta (2001) show that positive abnormal returns can be obtained following revisions of analysts’ recommendations. Menendez (2005) analyses buy and sell recommendations published in one of the most important Spanish business newspaper (Cinco días) for the period 1997-1999. Both papers report positive and significant risk-adjusted returns the days before the recommendation is made public. More recently, Espinosa & Sala (2006) obtain similar conclusions, analyzing consensus instead of individual recommendations. And lastly, a study based on the same database of this thesis (the Spanish business newspaper “Expansion”) from Blandón & Bosch (2009) reveals that analysts’ recommendations have a significant influence on stocks returns the day of publication of the recommendation.
On the other hand, Altınkılıç and Hansen (2009) found that analysts’ recommendations and forecasts are usually issued immediately after company events so that they “piggyback” on the momentum. Therefore, observed price reactions should not be associated with the analysts’ recommendation changes but rather should be attributable to the company news that immediately preceded the revisions (Altınkılıç and Hansen, 2009).
The goal of this thesis is to investigate whether investors can earn abnormal stock returns when they follow a trading strategy following sell-side analysts’ recommendations and the changes in those recommendations in the Spanish market. More than 5000 recommendations were used in an event-study methodology to analyse the market’s reaction to these recommendations. I contribute to the current literature by examining the value of analyst recommendations using data for the period between 2010 and 2017 collected in a database from a widely known newspaper in Spain called “Expansión” and complemented with stock prices obtained from DataStream database. From an academic perspective, this thesis aims to give a better understanding of the effect of analysts’ recommendations and changes in stocks returns. From the perspective of investors, provide an idea of the usefulness (and limitations) of analyst recommendations in investment decisions.