Analyst recommendations and investment strategies in ADRs: star and non-star reputation

Abstract

Sell-side analysts have become one of the key intermediaries in the capital markets linking investors and publicly traded corporations. The importance of sell-side analysts has developed since late 90th, when sell-side research market was valued in billion dollars. During this period media started to question the inner value of analysts reports and the content of the report, that is recommendations, earning estimates, and target price revisions. Specifically, they were blamed for receiving huge compensation for being lucky, because under efficient market hypothesis, it is impossible to generate access returns. Following the rising media concern, academic community started to study the nature of sell-side analysts and their reports. First, scholars were interested whether analyst recommendations, target price revisions are able to impact the stock prices, without mentioning the profitability pattern. Having proved that analyst recommendations are able to change stock prices, the next topic of interest was whether the stock reaction to analyst recommendation results in profitability, which is higher than the market return (e.g., S&P 500). In continuation, more and more studies appeared linking recommendation profitability with various analyst and brokerage house related attributes, such as reputation, size of the brokerage house etc. However, there is no strict conclusions on the analyst performance and recommendation profitability since scholars used different samples, methods, or rankings. As a continuation of recent studies, this paper examines whether the analysts’ recommendations can generate abnormal return and whether the analysts ranked as Stars in StarMine’s “Top Stock Pickers” and “Top Earnings Estimators” rankings make more profitable recommendations in comparison to Non-Star group. Previously, only one paper compared 3 different rankings and concluded that rankings issues by Institutional Investor magazine - which are most often utilized in the literature - are subjective. Hence, this study is the second to utilize StarMine’s objective ranking’s hand-collected data. The sample of the research is narrowed to American Depositary Stock receipts to see whether recommendations differently touch the stocks of foreign companies. By applying buy-and-hold calendar-time-portfolios methodology with 30-day holding period, 2 portfolios (Long and Short) are formed for each Stars, Non-stars, and Star-1 groups resulting in 6 portfolios. The access returns of the portfolios are calculated using Fama-French 3/5/6 factor models with different risk factors. The results suggest that in the Long portfolio, Stars underperform Non-stars, while in the Short portfolio Stars and both Star-1 outperform Non-stars. The reason behind underperforming Stars in Long portfolio is mostly explained by risk-aversion of Stars in recommending risky stocks, while Non-stars “have nothing to lose” and take higher risk by recommending large number of ADRs. The same explains the outperformance of Stars in Short portfolio since Stars tend to conduct advanced research before shorting risky stocks.