The Little Book of Stock Market Profits

The Best Strategies of All Time Made Even Better

Mitch Zacks

• Publisher: Wiley
• Year: 2011
• Print ISBN: 9780470903414
• eBook ISBN: 9781118192412
• Edition: 1
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

A timely guide to making the best investment strategies even better

A wide variety of strategies have been identified over the years, which purportedly outperform the stock market. Some of these include buying undervalued stocks while others rely on technical analysis techniques. It's fair to say no one method is fool proof and most go through both up and down periods. The challenge for an investor is picking the right method at the right time. The Little Book of Stock Market Profits shows you how to achieve this elusive goal and make the most of your time in today's markets.

Written by Mitch Zacks, Senior Portfolio Manager of Zacks Investment Management, this latest title in the Little Book series reveals stock market strategies that really work and then shows you how they can be made even better. It skillfully highlights earnings-based investing strategies, the hallmark of the Zacks process, but it also identifies strategies based on valuations, seasonal patterns and price momentum.

Specifically, the book:

• Identifies stock market investment strategies that work, those that don't, and what it takes for an individual investor to truly succeed in today's dynamic market
• Discusses how the performance of each strategy examined can be improved by combining into them into a multifactor approach
• Gives investors a clear path to integrating the best investment strategies of all time into their own personal portfolio

Investing can be difficult, but with the right strategies you can improve your overall performance. The Little book of Stock Market Profits will show you how.

Chapter One

The Crystal Ball of Wall Street

Analyst Recommendations and the Future

It is very hard to predict the future. Think about something you like to analyze for fun—such as following the local sports team. In Chicago there are two baseball teams, the White Sox and the Cubs. The two teams face off against each other in what is called the Crosstown Classic. Now no matter how die-hard a Cubs fan you are or what your knowledge of the White Sox is—trying to predict which team will beat the point spread is incredibly difficult. No matter what you think you know about the Cubs, the information is likely reflected in the point spread.

Trying to beat the market is very similar—a stock may in fact be a good buy due to various fundamental reasons, but this information is likely already reflected in the stock’s price. If you’re trying to select a stock to outperform the market, find a stock for which new information is not currently reflected in the stock’s price. Brokerage firms attempt to do this by hiring research analysts.

An investor’s first introduction to the work of research analysts is often listening to and acting on a stock recommendation provided by a full-service broker. An investor will purchase a stock because the research analysts at the broker’s firm have issued a recommendation to buy. Sometimes a recommended stock will go up, sometimes it will go down. Perhaps the broker will provide a string of prescient recommendations. More likely than not, though, acting on the broker’s recommendation will not result in a windfall for the investor. The next logical question for the investor is whether this is because of the broker, the research analysts at the brokerage firm, or simply due to being a small-fry client to the brokerage firm. The answer to this question lies at the heart of the study of investment strategies based on analysts’ recommendations.

Meet the Analyst

Meet Matt, an analyst working at a Wall Street Brokerage firm. Most likely he has graduated from a top-tier MBA program within the past decade or two. Since graduating from business school, Matt has been following the same group of 10 stocks in the enterprise software sector. Unlike an analyst who works for a mutual fund and who has to be moderately familiar with a large number of stocks, Matt is likely one of five or six people in the country who is an expert on the 10 enterprise software companies that he follows.

Matt spends his time researching the companies he follows, meeting with the senior level management, analyzing the industry, and trying to predict which of the companies will be successful. He often talks directly with high-level investors regarding the prospects of the companies that he follows, and he writes extensive research reports on what’s going on with them.

The research reports written by analysts like Matt usually contain an estimate of what a company is going to earn on a per-share basis over the next two fiscal years; an estimate of how fast the company is expected to grow its earnings over the next five years; a recommendation of whether an investor should buy, hold, or sell the stock; a target price indicating what the analyst feels the stock should trade at over the next year; and lastly, a detailed explanation illustrating how these results are derived. The report usually contains a spreadsheet that shows the financial estimates behind the earnings projection, and it can be anywhere from a few pages to a short treatise to a semiannual opus.

These research reports are then provided to investors by the brokerage firm in exchange for trading revenue. This means that retail and individual investors who execute trades through a brokerage firm usually can access the firm’s proprietary equity research.

However, many retail investors do not spend the time and effort to actually read the report; instead they tend to focus on the recommendation of the report and blindly follow the advice. Unfortunately, this is far from the best way to use the research.

Listen—But Only if Simon Says “Change”

The purpose of the recommendation is to boil down the fundamental research of the analyst into one actionable suggestion. Do you buy, hold, or sell a stock? Unfortunately, the answer is not always clear. Here’s a hint if you want the Cliff’s Notes version: Focus on recent recommendation changes from analysts with good track records in small-cap stocks.

Analysts in the United States are collectively paid more than $7 billion each year to tell investors which stocks to buy and which to sell. At the most basic level, there has to be some value to the research analysts’ work. If there was not any value in the work, it is unlikely that investment banks, which are usually focused on the bottom line, would continue to pay analysts so much. Research seems to back this up—the analyst recommendations are useful in certain ways.

Analysts in the United States are collectively paid more than $7 billion each year to tell investors which stocks to buy and which to sell. At the most basic level there has to be some value to the research analysts’ work. If there was not any value in the work, it is unlikely that investment banks, which are usually focused on the bottom line, would continue to pay analysts so much.

There are a few firms worldwide that track analyst recommendations and their performance in the marketplace. One such company is my firm, Zacks Investment Research. In fact, we were the first firm in the country to begin tracking analyst recommendations; as a result, our database of recommendations has the longest history of any company, dating back to the early 1980s.

Research shows that:

1. Changes in analysts’ recommendations can be used profitably. The key here is whether an analyst has provided new information to the marketplace by changing his view on a stock.

2. Transaction costs can dramatically reduce the return of recommendation-based strategies.

3. Changes in analysts’ recommendations work better with smaller companies (that is, smaller capitalization stocks).

4. You can make more money by using recommendation changes in combination with other criteria.

5. Some analysts tend to have a greater effect on stock prices than others. One way to determine which analyst to follow is to track the analyst’s historical accuracy in making stock recommendations.

After roughly two decades of research it looks like analysts’ recommendations can be used profitably if the focus is on changes in recommendations as opposed to the level of the recommendation. It is more important if an analyst has recently changed his recommendation than if the analyst has been indicating a stock is a strong buy for the six months.

Tale of the Tape

One of the simplest investment strategies is to create portfolios based upon what analysts are recommending. That is, you buy the stocks the analyst tells you to buy and sell the stocks the analyst tells you to sell. The basic idea here is that the analyst’s recommendation has some predictive ability—that is, those stocks an analyst recommends as a buy should outperform, while those stocks an analyst recommends as a sell should underperform.

Let’s say that every calendar quarter you sort all the stocks for which analysts have issued recommendations for into two groups. The first group consists of the top 10 percent of stocks for which analysts are the most positive, and the second group consists of the bottom 10 percent of stocks for which analysts are the most negative. You buy and hold each portfolio for a quarter, and then you create the portfolios again next quarter with new data. From 1990 through 2010, the basket of stocks for which analysts were the most positive outperformed the basket of stocks for which analysts were the least positive in 14 of the 21 years. The strategy of going long stocks recommended by analysts and shorting the stocks analysts indicated you should avoid worked from 1990 to 1997, but then the strategy fell apart.

Let’s repeat the experiment from before. This time, instead of sorting the stocks based on the level of recommendations, sort the stocks into 10 groups based on the changes in recommendations that occur over the last month before the end of the quarter.

The good portfolio consists of the top 10 percent of stocks receiving the strongest magnitude of recommendation upgrades over the past month, and the bad portfolio consists of the bottom 10 percent of stocks that are receiving the largest magnitude of recommendation downgrades. In this case, examining the same time period as before, from 1990 through 2010, the basket of stocks consisting of those stocks receiving strong recommendation upgrades outperformed the basket receiving substantial recommendation downgrades in 19 of the past 21 years.

Results become even stronger when the creation of the portfolios is closer to the time of the recommendation changes. Studies have shown that excess returns increase substantially when the rebalance frequency—the period in which you are creating the basket of stocks based on changes in recommendations—is shifted from monthly to weekly, and it increases again when the rebalance frequency is shifted to daily. However, the data show that the returns from recommendation-based strategies are very volatile over time and are highly dependent on transaction costs.

Effectively, with recommendation-based strategies it’s a crapshoot whether any given year will be profitable for the strategy. This means that statistically over time the strategy of focusing on changes in analysts’ recommendations should generate market-beating returns, but any given year could result in positive excess returns or negative excess returns relative to a simple buy and hold strategy. Because of this volatility, it is necessary when employing recommendation-based strategies to try to implement the strategy through a full market cycle measured in years, not months.

Paying the Tolls

The other issue with recommendation-based strategies concerns transaction costs. Transaction costs can be broken down into four major categories:

1. Commissions

2. Bid/ask spreads

3. Price impact

4. Liquidity costs

First and foremost are the actual commissions that an investor has to pay for transacting in stocks. If you buy a share of stock through a discount online brokerage firm, your account will be charged a flat commission. For example, you are charged $9.99 for executing a trade through any one of a dozen online brokerage firms.

Institutional investors are charged commissions, but they are often quoted as a certain number of cents per share traded. Institutional commissions are also constantly moving lower; currently it is not unheard of for an institutional investor to pay a fraction of a penny per share in commission costs.

However, commissions can be seen as only the tip in an iceberg of costs and frictions involved in stock transactions. Much more pernicious is a whole slew of costs such as the bid/ask spreads, price impact, and liquidity costs that represent a much larger portion of transaction costs. When the full iceberg of transaction costs is considered—not just the commission tip sticking out of the water—it is clear that trading strategies based on recommendations should seek to minimize the turnover or frequency of transactions.

For instance, a recent study of a recommendation-based trading strategy, where an investor would simply buy those companies with the best recommendations, shows an annualized abnormal return of 9.4 percent. However, after accounting for transaction costs, the excess annual return falls to –3.1 percent.

Studies of recommendation data that try to incorporate transaction costs are quite controversial, simply because there is no accepted means of estimating transaction costs. The estimate of transaction costs tends to decrease over time as information technology improves. The transaction costs incurred for buying stocks in 1982 were higher than those incurred in 2002, which in turn were higher than in 2010. Additionally, investment strategies that focus on the level of analyst recommendations tend to be relatively unpredictable in the returns they generate. It is not uncommon to see results swing dramatically from year to year with no change in the criteria used for portfolio creation. Thus the risk-adjusted return of pure recommendation-based strategies tends to be lower than that for other investment anomalies.

Smaller is Better

Practically all studies of recommendation-based investment strategies indicate that the excess return of the strategies remains concentrated in small firms. A firm’s size refers to its market capitalization or the aggregate value of its equity. Small firms are usually, but not always, followed by fewer analysts.

The reason small-cap stocks respond better to recommendation changes could be that the market is less efficient for smaller firms and the amount of information is more limited. Another possibility is that the higher transaction costs for smaller firms prevent large institutional traders from trading in the small-cap stocks and eliminating the excess returns due to the recommendation changes. This does not appear to be unique for recommendation-based trading strategies—most anomalies seem to work better in smaller-cap stocks. The key is whether the excess returns continue to persist after adjusting for the transaction costs.

Combo Attacks

For even better returns, we can try combining information by using analyst recommendations with other fundamental data. For instance, a recent study showed that if you buy stocks with positive recommendations, the excess returns generated are higher when you also combine the additional factors of high price momentum, attractive valuation multiples and high earnings quality. Additionally, by incorporatin...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Introduction
• Chapter One: The Crystal Ball of Wall Street
• Chapter Two: Size Matters
• Chapter Three: Once More Unto the Breach
• Chapter Four: The Big Mo
• Chapter Five: The Inside Story
• Chapter Six: Song of the Shares
• Chapter Seven: Cash Is King
• Chapter Eight: It’s Worth What?!
• Chapter Nine: Earnings Surprises: The Gift that Keeps on Giving
• Chapter Ten: A Time to Plant and a Time to Reap
• Chapter Eleven: The More the Merrier
• Acknowledgments