Beware the Sell-Side Analysts

I thought I would publish some auxiliary results to an empirical study I have been working on, as they might be of direct interest to investors like me. I was able to get a large amount of data on analyst forecasts and corresponding corporate earnings announcements from a Thompson Financial database called the Institutional Brokers Estimates System.

The database contains data on the earnings announced each quarter by a company and the mean estimate for that quarter’s earnings among all analysts that follow the stock. I got all the data available dating back to 1984 and found the average difference between the forecast and the actual earnings. I call this “forecast error.” The bottom line is that analysts consistently overestimate earnings. This indicates that there are probably more earnings disappointments than there are surprises, or that disappointments are sometimes so large that they skew the results. The average forecast error is consistently positive, after accounting for nearly 250,000 quarterly earnings announcements over this time. In fact, in only two years, 2002 and 2003, was the error negative, indicating that analysts on average underestimated earnings in those years.

So how can we interpret these results? I hesitate to draw too many inferences as doing so might be seen as hasty by my academic colleagues. So I will leave that up to the reader. But it is not particularly surprising to me that stock analysts hired by brokerages or investment banks looking to make stock transactions happen would be overly bullish about a firm’s prospects. Or, alternatively, perhaps these analysts aren’t doing much thinking themselves and are instead merely following the guidance of the company, whose incentives are also obviously biased towards bullishness.

Regardless of the interpretation, this unambiguously suggests taking the pervasive “strong buy” recommendation with a grain of salt. But of course, we already knew that.