Analyst Errors and Investment Strategies: Can Investors Turn Bias into Benefit?

• Gerstein Fisher recently conducted research into the relationship between securities analysts’ long-term growth forecasts and actual stock performance.
• The research uncovered a pattern of systematic biases within analyst forecasts in fundamental or “hard” growth estimates.
• We believe that these systematic errors can be exploited through a quantitative, factor-based approach to investing.

How useful are security analysts’ long-term growth forecasts for stock investors? We recently completed a comprehensive statistical study of the link between sell-side analysts’ forecasts, subsequent realized earnings and actual future stock returns. We concluded that analyst forecasts can in fact be quite useful for investors—but not in the way you might expect.

Using consensus analyst long-term forecasts for annualized earnings growth taken from I/B/E/S, we decomposed the forecasts into two components, hard growth and soft growth. The hard- growth component captures accounting fundamentals, including growth in assets and sales, profitability, and equity dilution. Soft growth is a residual (the difference between long-term growth forecasts and the hard-growth component) which reflects analysts’ personal views of a stock that cannot be explained by observable accounting fundamentals.

A Pattern of Errors

What we find is a pattern of errors, or biases, built into analysts’ long-term growth expectations in quite a systematic way. In particular, the forecasts suggest that analysts believe profits are mean-reverting, while in fact profitability tends to be fairly persistent. The forecasts also indicate that analysts believe high past company sales growth is a good predictor of future earnings growth, while the actual relationship is negative. Finally, analysts believe that two activities over which company managements exercise direct control—a high rate of asset growth and the use of external financing– augur well for earnings growth; in fact, our research shows that enterprise decisions such as asset expansion and raising more equity are actually negatively  related to realized earnings growth. Meanwhile, our study concludes that the “soft growth” component is unrelated to stock returns.

Exhibit 1 depicts the large gap between consensus analyst long-term earnings forecasts (from 1982 to 2014) and the 5-year realized annualized growth rate (from 1982 to 2009). During this time frame, the mean estimated growth rate was remarkably stable, rising from 15.4% in 1982 to 19.7% in 2001 and declining to 14% in 2014. Meanwhile, the actual 5-year growth rate (e.g., 1982 reflects the five years from 1982 to 1987) fluctuated quite dramatically from slightly above 0% to 17.8%.

While a good brief summary, the chart and explanation above do not do justice to our full research report, Analyst Long-term Growth Forecasts, Accounting Fundamentals, and Stock Returns .

One inevitable question from this analysis is, given a consistent pattern of bias and errors in how analysts perceive hard information (accounting fundamentals) and make earnings growth forecasts, can investors actually make use of this bias to construct investment strategies? We think the answer to this question is yes . Quantitative multi-factor investment strategies are essentially a method to buy stocks when the hard component of growth is unfavorable and to sell when the hard component is favorable. To view a brief article that discusses some of the investment factors that relate to systematic biases, see “ A Third Way: Multi-Factor Investing Evolves .”

Disclosure:

Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Gerstein, Fisher & Associates, Inc.), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Gerstein, Fisher & Associates, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Gerstein, Fisher & Associates, Inc. is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Gerstein, Fisher & Associates, Inc.’s current written disclosure statement discussing our advisory services and fees is available for review upon request.