How The Analyst Rating Index Captures Market Improvers

During their recent episode, Taylor, Carlisle, and Steve Hou discussed How The Analyst Rating Index Captures Market Improvers. Here’s an excerpt from the episode:

Steve: So, yeah, thank you. That’s another paper that I put out recently, actually, just a few weeks ago. This is a concept we came up with by looking at analyst ratings. So, everyone has heard Beyond stock price, the first thing people often look at when they hear a new stock is to go look at how well rated it is by Wall Street analysts. Now, ANR is the function on the terminal. If you have terminal and you type in the ticker, you type ANR, you tell you all that different Wall Street sales analysts, their rating of the stock, whether it’s a strong buy, buy a hold, sell, strong sell. And it also gives you price targets, it gives you detailed research colors.

Now, how do you leverage something like in forming an investable strategy in a systematic way? One obvious thing you can do is just to buy up all the ones that analysts love. You get all the top strong buys. You get your Nvidia, you get your Apple, Tesla. Well, maybe not Tesla, because Tesla is famously hated by [chuckles] analysts, because– [crosstalk]

Jake: And you short that basket, right? That’s got to be the–

[laughter]

Steve: So, what we found interesting is that while if you go and just form the portfolio of the top 50 most beloved stock by analysts, like say, equal weight or some market weight or whatever, and you compare to the broader index, you’ve done all right over the last 20 years. If not underperformed, but you’ve also not really, consistently outperformed. This outperformed as well as the broad market.

Now, we were thinking, what if you do something a little bit different? One thing is that we know is analysts, often, they are not wrong, but they can be late. They can jump on the bandwagon. By the time all the analysts come to love a stock when the consensus rating is like a strong buy, a lot of upside has already been realized and the stock has already had a good run.

Now, one thing you can potentially do is to say, “What if I toss out all the ones that analysts tell me to buy?” I look at the stocks whose consensus rating has improved the most in most recent period. So, I will construct a metric that is very similar to how you will construct a price momentum metric, where I look at the average improvement in a consensus rating of a stock from the last 6 months and the last 12 months, just to average out those two. That’s how you will construct a price momentum signal, 12 minus 2 and 6 minus 2.

You build that portfolio and you find what’s interesting is that portfolio, on an equator basis, let’s say consumable construction, has actually, vastly outperformed the broader market over the last 20 years. This index is also on the terminal, the ticker is BANRT. So, BANR is Bloomberg analyst rating and the T is total return index. I can go into the intuition of why that works, but that’s the index.

Tobias: I would like you to do that. Just before you do it, just to clarify, you’re looking at the– it’s the momentum of the ratings or its price moments– [crosstalk]

Jake: It’s the first derivative of the analyst ratings.

Steve: Correct. So, let’s say a stock, today’s rating is 3.8 out of 5, because we normalize everything from one to five, one being strong sell and five being strong buy. If a stock today has 3.8, I used to have a 2.9, that difference is 0.9. I’ll compute that metric for every stock and I’ll pick the ones that improve the most, except I will toss out all the ones that today has a buy rating on it.

Tobias: And that’s a five rating.

Steve: Well, that would be a four and above.

Tobias: Four and above. Okay.

Steve: Four would be a buy and five would be a strong buy. So, between four and five is a range of buys of various types.

Tobias: Yeah, keep on going. You were going to say something before I interrupted you before.

Steve: Yeah. So, it’s very interesting. One, it’s not obvious something like this will work and two, if it worked, you almost expect this thing is just going to be exclusively price momentum. It turns out it works, but it’s not price momentum. In fact, it has a very strong value tilt.

We end up picking up on a bunch of turnaround companies, companies that have fallen on hard times whose fortunes are turning, but have not quite turned so much that analysts are reaching consensus just yet. In terms of that exposure, you have value exposure, you have either vol, because different companies can have hard time for different reasons. Like, most on the white paper, I read about a few examples. I mentioned Hershey’s, because of the price of cocoa. It got hit by that. Netflix, because of password sharing. And most recently, this company– What’s the company that Larry Ellison owns?

Jake: Oracle.

Steve: Oracle. Yes, Oracle has had a turnaround. Oracle is falling on hard times of being hated. And suddenly, AI kicks in, all the AI servers has just gone vertical. And then, we buy it and we dump it, because it became too beloved and you got a rating more than four. But that’s the intuition.

Tobias: So, it’s improvers rather than–

Jake: Winners.

Steve: Correct.

Tobias: Whatever that ticker be neutral, but because it’s improving from sell, then it’s preferred.

Steve: That’s right. I’m agnostic about from when it’s improved. It could be middling.

Jake: Yeah, strong sell.

Steve: Yeah. But although with so much great rating inflation– I mentioned this pretty interesting, the paper that there’s so much rating average inflation over the last 20 years, all the stocks are becoming more beloved. Obviously, underlying fundamentals of US stocks have also become better that you see this consensus rating median going up and up. What I like about this metric of the momentum improver one, is that it’s more or less centered around zero. It doesn’t go up with the average level. So, at any given moment, there are some companies that are getting better, some companies that are getting worse.

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