Analysts and future stock market returns - some Indian evidence

Ashok Desai has an interesting column titled Unsolicited exhortations in the latest Business World about the performance of stock market analysts in India:

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I came across a recent book written by Rajesh Chakrabarti (The Financial Sector in India: Emerging Issues, Oxford). There he takes 2,190 recommendations on 310 companies by analysts from 25 firms and a newspaper between January 1998 and July 2003. Of them, 46 per cent were strong buy, 21 per cent weak buy and 4 per cent neutral/buy; thus, three-quarters were buy recommendations of one sort or another. Only 9 per cent were sell recommendations. My suspicion that analysts give biased recommendations is fulfilled. Chakra-barti does not use such a strong word; he just calls it broker optimism.

Who were the worst optimists? Some gave only a handful of recommendations. Amongst those who gave over a hundred recommendations, Motilal Oswal was the most optimistic, with 89 buy recommendations out of 106. Pioneer (83/107), LKP (158/191) and SMIFS (130/164) were not far behind.

Who were the least optimistic? Business Line (136/283) was the leader. But it was not a pessimist. Rather, it enjoyed sitting on the fence; 108 of its recommendations were neutral. Rooshnil was similar; although 24 of its 54 recommendations were strong buy, another 18 were neutral. HDFC Securities was a cautious optimist: 54 of its 82 recommendations were to buy, but they were all weak buy. Although 158 of LKP Securities' recommendations were to buy, they also made 25 recommendations to sell. Moneypore had the largest proportion of recommendations to sell - 19 out of 125.

But maybe the optimists were right? Chakrabarti shows that they were on the average. Over the 80 days after strong buy recommendations, the stocks outperformed sensex. Not by much; the average rise in their prices at the end of 80 days was about 3 per cent, against 1.5 per cent in sensex. But the difference was statistically significant. Similarly, over the 80 days after strong sell recommendations, the fall in the stocks was greater than in sensex. Sensex fell about 3 per cent, and the stocks about 4 per cent; but again, the difference was significant, though not always over the entire period of 80 days. It may be noted that sensex generally rose on the average after buy recommendations and fell after sell recommendations; the recommendations were thus partly based on a forecast of the market trend.

Did the analysts lead investors to buy or unload shares, influence the price and thereby fulfil the analysts' forecasts? To test whether they did, Chakrabarti compared the average price in the five days preceding the forecast to it in the five days after the forecast, and similarly for 20 days, and found a definite correspondence between the direction of the forecast and of the price change - more in the case of sell than of buy recommendations. Thus, herd behaviour of those investors who follow analysts helped the latter prove right.