The Analyst Bias Effect

"Wells Fargo & Co Increases Patrick Industries (NASDAQ:PATK) Price Target to $49.00 - Modern Readers" - 2019-03-17

Analyst predictions have an effect on stock prices. Investors can key into analyst ratings and recommendations to understand the future prospect of a stock. You can stay up to date with the most recent analyst predictions through our Market Mentions Tool or a variety of other tools such as the Nasdaq Tracker.

Institutions rely on their analysts to identify good purchasing opportunities and analyst recommendations are used by large institutions to reallocate fund resources.

However, some recommendations influence stock prices more than others so it is important to understand which predictions matter.

Every so often we conduct our own analysis on our FMI data to identify which institutions are the most accurate target price forecasters. Our last study summary can be found here.

Academic Research

We are not the only ones analyzing analysts. Researchers Youngdeok Lim and Hyunglae Kim recently released a paper called Market reaction to optimistic bias in the recommendations of chaebol-affiliated analysts.

First, what is a chaebol-affiliated analyst?

In Kyojik Song, Thmas Mantecon, and Z. Ayca Altintig's Chaelbol-affiliated analysts: Conflicts of interest and market responses released on February 2012, the researchers defined a chaebol-affiliated analyst as an analyst working for a Korean business group that has a large stake in the securities the analysts is reporting on. They found that analysts tended to be more optimistic on the stocks they analyzed. They posted 2.5% higher target prices and 2% higher EPS forecasts than other chaebol and independent analysts. The analysts concluded that capital markets to do recognize the conflicts of interests (biases) that these analysts have.

Our 2019 article is a follow up to the initial observation in 2019. Lim and Kim found that the market is now recognizing the conflict of interest that affiliated analysts have, and discounting the optimism. They found that in the short term, the chaebol-affilitaed 'buy' recommendations saw much lower returns than other analyst buy recommendations. However, they also found that long-term market returns of affiliated stocks were actually more profitable.

What we are seeing is that investors are beginning to comprehend analyst biases (at least in Korea) and be more cautious in the short term. However, institutional investors who cannot enter and exit quickly due to their size, are still using these ratings to re-allocate resources, thus causing long-term returns to increase significantly.

Applicability

Don't day trade on analyst recommendations.

When assessing an investment recommendation, understand the investment banks' track record and holdings.

Analyst ratings are determined based on long-term DCF and comps models and attempt to model the stock's future growth.

Institutional investors still use analyst predictions, so the best returns come from getting in early and holding; even if the stock goes down in the short term.

Analysts are biased. Incorporate your own unbiased analysis when purchasing a stock. Use our stock scorer to help.

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