Consensus Recommendation Screen: Is it worth listening to Strong Buys from Brokers?

Tuesday, Jul 19 2011 by
Consensus Recommendation Screen Is it worth listening to Strong Buys from Brokers

In Brief 

A recommendation level screen would focus on buying the most recommended stocks in the market based on the broker consensus. This is to be contrasted with a screen that focuses on those stocks most recently upgraded - a ‘recommendation revision’ screen. Overall, it appears that the absolute level of published stock recommendations has little (or even detrimental) value to investors, but monitoring the changes in investment recommendations can prove more productive.


Broker recommendations as to whether clients should buy, sell or hold stocks  are widely reported in the media. Despite this, the value of these recommendations is hotly debated. The issue is that broker recommendations have historically exhibited a strong upward bias. Researchers Jegadeesh, Kim, Krische and Lee found that the average analyst rating over the 1985 to 1999 period was close to a buy recommendation and sell or strong sell recommendation made up less than 5% of all recommendations. This is because most sell-side analysts work for brokerage houses which often have strong investment banking franchises, creating a  potential conflict of interest when firms act as investment bankers to the companies their analysts cover. Following the debacle of the late 1990s, legislators have taken action to address this conflict. The US Global Analyst Research Settlement of April 2003, the EU’s Markets in Financials Instruments Directive of 2004 (MiFID) both targeted the fairness of research. Although this appears to have had some impact, recommendations still have remained relatively optimistic - research by Jegadeesh and Kim in 2006 indicated that analyst recommendations retain a significant element of favourable bias.  

Definition of a Consensus Recommendation Level Screen

A somewhat simplistic screen based on pure recommendation levels might, say, buy the most favorably recommended quintile of stocks according to the consensus, and sell the least favorably recommended quintile of stocks. 

Does that work?

The evidence is mixed but most research suggests that it doesn't, especially after transaction costs and assuming a more medium term investment horizon. Early work by Womack did find short term excess returns (3-5% over a three day period) as well as longer term post recommendation drift.  However, Barber et al found that, while a trading strategy was profiltable before transaction cost, returns after taking into account costs were insignificant.  Furthermore, a subsequent paper taking into account the…

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