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Big Picture

Mid ranking shares often best value

10 Dec 2013 90 month(s) ago

rankBroker recommendations should be taken with a grain of salt. DIY fund investors can often do better by betting against them, according to one broker report.

rankOne of the more interesting aspects of investment is that the most popular stocks, and the least popular stocks, tend to underperform. It is the mid-ranking companies, which typically do not get much attention, that tend to do the best. Deutsche Bank has released a report looking at this:

"This report examines what the consensus of analyst recommendations can tell us about relative stock performance. To assess this, we calculate the relative return over time of owning each quintile of stocks by popularity, with a quarterly re-balance. Our findings indicate that the most and least popular 20% of stocks have performed the worst, with middle quintiles performing best.
What could explain this?
The market is likely to discuss popular stocks more, making investors familiar with the investment thesis. As a result, interested investors may have already bought the stock, leaving few marginal buyers. The least popular stocks tend to have the most ?‘sell?’ recommendations. Such recommendations aren?’t very common (~15% of ratings, vs 40-45% for ?‘buys?’ and ?‘holds?’), giving them scarcity value which the market may be more likely to act upon."

The Deutsche analysis suggests that banks are dangerous and resources are more in the mid-ranking tier that proves profitable:

"Banks popular relative to history, resources neutral
At the sector level, banks and defensive industrials are quite popular relative to history, which suggests caution. In contrast, sentiment towards resources is broadly neutral. Amongst cyclical industrials, offshore cyclicals are quite popular and resource-related names are not. The more neutral areas are domestic cyclicals and financial-market exposed stocks.
Stock implications
DB buy-rated stocks in the attractive 2nd, 3rd, & 4th quintiles include: Asciano, Aristocrat, ANZ, BHP, Lend Lease, Myer, Oil Search, Orica, QBE, Rio Tinto, Santos, Toll, Woolworths (all of which are in our model portfolio). Others include Amcor, Challenger, Jamies Hardie, Sonic, Tabcorp, Westfield Group, WorleyParsons."

As the graph below shows, analysts tend to be unreliable. Often they reflect the conventional wisdom, which is what the market bets against. Indeed, it is in analysts' interests to provide conventional wisdom. Being too far away from the crowd runs the risk of getting it conspicuously wrong. It is better to be like everyone else in being half right or wrong than standing out from the crowd. It is a career choice. Here is the evidence of why it is good to be sceptical:

The upshot? Sell recommendations are not necessarily a reason to shy away from investing in a  company. Provided the company is sustainable, it won't collapse, it is often quite likely to rebound and provide investors with good returns.