Why Seeking Alpha Recommendations Outperform Mutual Funds And Brokerage Analysts

By | October 8, 2015

Scalper1 News

Summary Academic research indicates that, on average, Seeking Alpha recommendations outperform mutual funds and brokerage (sell-side) analysts by substantial margins. The SA coverage universe includes many small company stocks that are ignored by sell-side analysts, despite the longstanding and significant negative correlation between returns and market cap. SA contributors are far more likely than sell-side analysts to issue sell recommendations when circumstances warrant, thereby avoiding losses and exploiting opportunities to short. SA taps the “wisdom of crowds” via large numbers of highly trained contributors who are freer than brokerage analysts to develop and express individual stock ideas in great detail. Given the findings of academic studies at NYU and Purdue , there can be little doubt that Seeking Alpha (SA) recommendations, on average, actually do deliver substantial positive alpha. Nor can there be much doubt that actively managed equity mutual funds typically deliver negative alpha . With respect to sell-side analysts, a 2014 academic study of their performance found that only “about 50% of ‘buy’ recommendations issued by industry and market benchmarkers meet or beat their objective.” (Roughly as reliable, in other words, as basing one’s investment decisions on coin flips.) Fundamental Advantages of SA Research 1. Microcap and small cap stocks have a long history of outperforming large caps. As the NYU study noted, SA analysts often cover companies that are too small to attract coverage by brokerage analysts – or to be owned by mutual funds. When my Data Driven Investing co-author, Mitch Hardy, and I analyzed Compustat data for over 20,000 companies between 1951 and 2002, we found that an annually rebalanced portfolio of the 100 smallest stocks (with a minimum market cap of $10 million in 2002 dollars and assuming reinvestment of dividends at year end) would have grown from $1 to $4,418 ( 17.52% compounded annually ) during this 52-year period. This figure assumed that buys and sells were done for zero commission at year end closing prices, which is certainly an overly optimistic assumption. Nevertheless, it is a meaningful indicator of a powerful negative correlation between company size and investment returns when compared to the terminal values of $1 invested in similarly constructed portfolios with higher market cap minimums: $100 million minimum market cap – $1,293 terminal value (14.77% compounded annually) $250 million – $667 (13.32%) $500 million – $289 (11.51%) $1 billion – $303 (11.62%) S&P 500 – $254 (11.23%) 100 largest market caps – $148 (10.08%) From 1/1/03 through 10/2/15, this correlation has persisted. The Russell Mega Cap 50 has returned 139.9% (with dividends reinvested) vs. 199.9% for the Russell Microcap Index. 2. SA contributors are far more likely to issue sell recommendations when warranted than are sell-side analysts. Because brokerages have little to gain and much to lose from issuing negative reports, they make very few of them , thereby exposing their clients to avoidable losses, as well as causing clients to miss out on profitable short sale and put buying opportunities. Whereas almost all investors are potential buyers of the individual stocks that brokerage analysts recommend, relatively few are in a position to act upon sell recommendations. That is, unless an investor either owns a stock already or is inclined to short it (or buy puts), that investor will not act upon a sell recommendation. As a result, the potential commission revenue to be derived from making a negative call is relatively small. In addition, there are strong disincentives in play. Not only is the subject of a sell recommendation quite likely to look askance upon doing investment banking business with the brokerage that makes it, but it’s also possible for a single negative research piece to harm relationships with an entire industry . At the very least, going negative on a company can impede an analyst’s access to its management and the information needed to do his or her job. Moreover, these analysts have strong incentives to defend the stocks of companies that are either investment banking clients or prospects of their brokerages – even when short sellers put forth solid evidence of existential product liability problems and unsustainable business models. The next time Citron Research makes one of its “emperor has no clothes” calls, watch for one or more brokerage analysts to leap to the stock’s defense, however compelling the sell case might be. The more troubled the company, the more opportunity there may be to profitably pursue investment banking opportunities with it. Such companies may well be in the market for assistance from accommodative Wall Street firms in raising cash and/or dumping the stock owned by their managements upon unsuspecting investors. 3. SA contributors can focus far more attention than brokerage analysts on each opportunity they research. The SA posts of Citron provide us with prime examples of the thoroughness that brokerage analysts lack. (Click on the link in the preceding sentence to see what I mean.) The focus of sell-side analysts is necessarily diluted, due to the number of stocks they are assigned to cover, as well as their sales responsibilities. Academics have noted a negative correlation between analyst workload and accuracy (as well as a negative correlation between workload and research timeliness). Whereas it’s commonplace for a single sell-side analyst to have coverage responsibility for a dozen stocks or more (e.g. at Raymond James ), SA contributors have far more freedom to focus on developing one individual stock idea at a time. And when an important sell-side prospect or client needs handholding from an analyst, be it an institutional investor or investment banking-related, this may take precedence over research . 4. As the preeminent aggregator of crowdsourced investment research, SA is uniquely positioned to harness a large and growing pool of individuals with underutilized talent who are highly motivated to produce quality work. Many SA contributors (like yours truly , for instance) earn CFA designations with the hope of becoming an equity analyst or portfolio manager with an established firm. For those of us who will never realize this hope, SA provides an attractive means of pursuing our analytical passions, as well as a platform for sharing our analyses with, and receiving feedback from, thousands of viewers. Whether or not one has secured such a position, the rewards for writing insightful analyses can extend beyond the intellectual challenges, kudos from viewers, and penny per page view. There’s a reasonable chance that one’s audience will include someone impressed enough to make a suitable job offer or open a new account. The CFA charterholder population has roughly doubled during the past decade and now stands at over 123,000 – and there are more on the way, with more than 210,000 exam registrations received in 2014. Inevitably, this crop of CFA wannabees will ultimately yield a bounty of well-trained SA contributors. There are, of course, many highly competent SA contributors who do not hold CFA charters. Their numbers include underemployed MBAs, downsized financial services personnel, and those with no relevant formal training who have enough sense to know a good investment opportunity when they see one. In fact, when flooring contractors have something to say about Lumber Liquidators (NYSE: LL ), their observations carry more weight with me than whatever a desk-bound CFA/MBA type might have to offer. Whereas Wall Street firms offer no effective way for small investors to band together in challenging the assertions of their brokerage analysts, SA gives users the opportunity to publicly point out errors, unwarranted assumptions, and other shortcomings in the analyses submitted by its contributors. In addition, SA provides a convenient venue for critiquing the alleged wisdom of Wall Street. SA’s sharp-eyed editors constitute a first line of defense against the publication of factually incorrect or otherwise misleading submissions. And if significant deficiencies remain after publication, SA users’ multitude of eyeballs can generally be counted on to catch them. To the extent that the “wisdom of crowds” exists in the investment world – in contrast to the “madness of crowds” that is the Wall Street norm – it can be found at seekingalpha.com. Scalper1 News

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