The Stock Selection and Performance of Buy-Side Analysts
Executive Summary — Important differences between buy- and sell-side analysts are likely to affect their behavior and performance. While considerable research during the last twenty years has focused on the performance of sell-side analysts (that is, analysts who work for brokerage firms, investment banks, and independent research firms), much less is known about buy-side analysts (analysts for institutional investors such as mutual funds, pension funds, and hedge funds). This paper examines buy recommendation performance for analysts at a large, buy-side firm relative to analysts at sell-side firms throughout the period of mid-1997 to 2004. The researchers find evidence of differences in the stocks recommended by the buy- and sell-side analysts. The buy-side firm analysts recommended stocks with stock return volatility roughly half that of the average sell-side analyst, and market capitalizations almost seven times larger. These findings indicate that portfolio managers (buy-side analysts' clients) prefer that buy-side analysts cover less volatile and more liquid stocks. The study also finds that the buy-side firm analysts' stock recommendations are less optimistic than their sell-side counterparts, consistent with buy-side analysts facing fewer conflicts of interest. This and future studies may help sell-side and buy-side executives to allocate their financial and human resources more strategically. Key concepts include:
- The failure to find that buy-side research out-performs that of sell-side analysts raises questions about whether investment firms should continue to rely on their own research rather than using research from sell-side analysts.
- Buy-side firms' analysts issued recommendations for companies with lower stock return volatility and larger market capitalizations than typical sell-side firms.
- Buy-side firm analysts recommended stocks with stock return volatility roughly half that of the average sell-side analyst (0.42% versus 0.95%), and market capitalizations almost seven times larger ($9.1 billion versus $1.3 billion).
- For stocks covered by both buy- and sell-side analysts, there were no differences in the buy recommendations' performance.
- Resolving whether buy-side research creates value is highly relevant to managers at buy-side firms who are faced with the challenge of allocating limited research resources.
We examine the selection and performance of stocks recommended by analysts at a large investment firm relative to those of sell-side analysts during the period mid-1997 and 2004. The buy-side firm's analysts issued less optimistic recommendations for stocks with larger market capitalizations and lower return volatility than their sell-side peers, consistent with their facing fewer conflicts of interest and having a preference for liquid stocks. Tests with no controls for these effects indicated that annualized buy-side Strong Buy/Buy recommendations underperformed those for sell-side peers by 5.9% using market-adjusted returns and by 3.8% using four-factor model abnormal returns. However, these findings were driven primarily by differences in the market capitalization of the stocks recommended. After controlling for this size effect, we find no difference in the performance of the buy- and sell-side analysts' Strong Buy/Buy recommendations.