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One very public way that analysts make stock recommendations is in the WSJ "Dartboard" column. The column has run monthly since October 1988. Each month, the stock picks of four analysts (the "pros") are published along with four stocks picked at random by throwing darts (the "darts"). Six months later, the performance of the pros' picks and the darts are reported along with the return for the Dow Jones Industrial Average (DJIA). More recently, the WSJ has added four "readers" stocks that are picked from email suggestions by the paper's readers.

For example, in the February 15, 2001, issue of the WSJ, the "Dartboard" presented the picks of four analysts.6 The analysts and their picks were Joseph Battipaglia (buy LSI Logic), John Keegan (buy Oracle), Lanny Thorndike (buy Hartford Financial), and Jeanie Wyatt (buy Scientific-Atlanta). Do the analysts know something we don't? Do their stock picks outperform the market? If I buy their picks, will I beat the market?

In a quick review, I examined the contest results for the two years prior to writing this chapter (November 1999 to October 2001). Of the 24 contests, the pros' picks won 10 times, the darts won nine times, and the DJIA won five times. Not exactly a dominating performance by the analysts. In head-to-head competition with the darts, the pros beat the darts 13 times and lost 11 times.

A more formal analysis of the pros' picks includes a longer time-series and the magnitude of the returns. Financial economist Bing Liang examined the performance of the 216 analysts' recommendations in the 54 contests from 1990 to 1994.7 Each day after the publication of the "Dartboard," the daily returns of the stocks were examined. To determine the success of the picks, the performance was computed as an abnormal return. Think of the abnormal return as how much the stock beat the general stock market.8 A positive (negative) abnormal return means the stock did better (worse) than the market.

On the day of the WSJ publication, the average abnormal return for the analysts' picks is 2.84%. The day after the column is published results in an abnormal return of 0.68%. An investor who read the column and purchased the recommended stocks at the market open and then sold them at the market close the following day would have earned an average 3.54% return for each stock recommended. This return looks impressive for a two-day investment. Before you decide to use this as a trading strategy, remember transaction costs. The round trip (buy and sell) transaction cost for the typical online investor is 3.37% (transaction costs are discussed in Chapter 7, "Timing the Market").

Before you conclude that analysts' recommendations are superior investments, consider the longer term return of the pros' picks. To examine the return the investor would obtain for a longer holding period, the daily abnormal returns are added together following the column publication. The computation is called a cumulative abnormal return and is shown in Figure 5.2. The graph shows that the big gains during the publication day (day 0) and the first day afterward (day 1) are gradually reversed. All of the initial gains are gone two months after the recommendations are made. By the end of the six-month competition period, the pros' picks have underperformed the market by an average of 3.8%.

Figure 5.2Figure 5.2 Cumulative Abnormal Return of Analysts' Stock Picks after The Wall Street Journal's "Dartboard" Column Is Published

So what is going on here? The stock prices first jump up for a good return, and then the gain is slowly reversed. The evidence shows that when the analysts' recommendations are published, na?e investors who expect the stocks to outperform push up the prices of the recommended stocks. The price increases during this two-day initial buying spree. Indeed, the volume of the recommended stocks double during these two days. However, since the stock picks are actually no better than randomly picked stocks, this artificial price increase eventually dissipates. In fact, the darts outperformed the pros by an average 0.75 percent during the six-month competition.

It might be argued that although the average analyst recommendation might not be useful to the investor, the recommendations of the top analysts are useful. The WSJ "Dartboard" asks the two analysts with the highest return (out of the four) to return for the next competition and compete with two new analysts and four new dart picks. Surely these successful analysts can help us pick stocks! In his study, Professor Liang computed the abnormal return on the stock pick of the previous competition's winner. Na?e investors seem to really value the previous winner's pick, because trading volume tripled when the new stock pick was published in the column. The price pressure pushed the stock price up 5.4% in the first two days. However, by the end of the six-month period, these gains were lost. The cumulative abnormal return for the previous winners was an average –5.06%, which is even worse than the other analysts.

By the way, remember the four analysts mentioned at the beginning of this section? Six months later, their recommendations earned an average –17.3% return.9 This performance trounced the darts (–21.2%), but not the DJIA (–2.5%). It is very typical that the performance of the darts' and the pros' portfolios vary quite substantially from the DJIA. This occurs because these portfolios are very underdiversified when compared with the DJIA. Chapter 8, "Mutual Funds: Performance," illustrates the problems of underdiversification.

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