Should we trust Warren Buffett or Wall Street Analysts?

Have you ever wondered whether you could rely on the stock recommendations from the Wall Street analysts? Representing the brokerage firms and other institutions, these analysts can change the public opinion of a company to such extent that its share price may shift accordingly. Their recommendations, however, are not always accurate; sometimes even the experts get it wrong.

Warren Buffet’s view is that investors, on average and over time, will be better off passively investing in some low-cost index fund such as the S&P 500 index fund. He thinks that active investors, who plan to do better than average in securities markets, will incur far bigger costs than the passive ones (he has even made a bet on it: http://longbets.org/362/).

In this research, you will see whose advice is more profitable to follow: Wall Street analysts’ or Buffet’s. Trading in accordance with the analysts’ recommendations will represent active investing, while Warren Buffet’s approach — passive.

Profitability of Analysts’ recommendations

Analysts examine public companies by studying their financial statements, assessing their respective industries and accounting for many other factors that might affect their stock price. They then release the target price, which is what they think the company’s price should be. To get all analysts’ combined opinion of a company, we computed the average of all recently released target prices. The signal was bullish when the current share price was a lot lower than the average target price and bearish when the current share price was a lot higher than the average target price.

Those bullish and bearish signals were used to backtest (simulate trading using historical share prices) each of the S&P 500 companies one by one (as if the shares were bought and sold based on those signals). Next, we calculated the annual return the analysts’ recommendations have given for every S&P500 company and computed the average.

Each company was tested for the past 11 years to capture a full economic cycle including the Recession of 2008. Thus, the trading simulation started on 05/18/2007 and ended on 05/18/2018. The total number of buy and sell transactions amounted to 10,056 times, which means that, on average, there were 20 transactions made for each company. This part of the research was supposed to be the most time and energy consuming because of the need to consider all S&P 500 companies, but StockMetrix app has made the work much faster and easier. It has the analysts’ recommendations data and a backtesting facility.

Based on our research, following the recommendations from the Wall Street analysts when buying and selling shares of the S&P500 companies could have generated the average of 9.6% annual return (compounded). Note that transaction costs were not taken into account. We assume that investing was done via no commission brokerage service such as Robinhood.

Profitability of Warren Buffet’s idea

Buffet’s passive investing approach of buying and holding the S&P500 index fund on 05/18/2007 and selling it 11 years later could have made 8.22% annual return (compounded). The transaction costs were not accounted for in this case either.

Best and Worst companies to follow the Analysts

As a side note, you might be interested to find out what companies showed the highest and lowest returns in the trading simulation when it was based on the analysts’ recommendations. The table below shows the annual gain that could be achieved by fully following the analysts’ advice. We have also included the annual gain from the Buy and hold strategy (buying the stock on 05/18/2007 and selling it on 05/18/2018) for you to compare with the analysts’ results.

These results are something to bear in mind when reading the analysts’ reports on these 6 companies. Especially E-TRADE, the analysts’ would have made much larger losses than if you just bought the stock and watched it fall.

Conclusion

Active trading based on the Wall Street analysts’ recommendations regarding the S&P500 companies turned out to be more profitable than Buffet’s passive investing approach. It seems like you can trust the analysts after all. Even though Buffet’s approach earned less return, it is still very appealing: you do not have to do much — just buy and hold.