Posted by Joseph Y. Calhoun, III

Here’s an interesting study from three professors at Texas A&M:

Abstract:
We find that positions taken by short sellers that conflict with consensus analyst recommendations are highly informative about future returns, and investors can profit by trading with the shorts. A six-month, abnormal return of 9.6% can be earned from a zero-investment strategy that 1) shorts firms with highly favorable analyst recommendations (buy signal) but high short interest (sell signal), and 2) buys firms with highly unfavorable analyst recommendations (sell signal) but low short interest (buy signal). To understand why this strategy is so profitable, we investigate whether shorts and analysts differ in their use of information that prior research shows to be predictive of future returns. We find that analysts tend to over-recommend stocks with high growth and high accruals - despite a negative association with future returns. In contrast, short sellers correctly use this and other fundamental analysis information to identify situations when analysts’ recommendations are misleading.

More specifically:

• A hedge strategy that is long (short) the 20% of stocks with the highest (lowest) average analyst recommendation, rebalanced quarterly during 1994-2006, has an average six-month return of -3.3%. The subperiod 1999-2003, with an average return of -7.8%, drives this negative result. Average returns are insignificant for the subperiods 1994-1998 and 2004-2006.
• A hedge strategy that is long (short) the 20% of stocks with the most positive (negative) average change in analyst recommendation, rebalanced quarterly during 1994-2006, has an average six-month return of +2.3% (but insignificant during the 2004-2006 subperiod).
• A hedge strategy that is long (short) the 20% of stocks with the lowest (highest) short interest, rebalanced quarterly during 1994-2006, has an average six-month return of +4.3% (positive in each sub-period but statistically reliable only for 2004-2006).
• Investors can boost abnormal returns by combining analyst recommendations and short interest (double-sorting first on the former and then on the latter), with the largest returns occurring when short sellers disagree with analyst recommendations.
• A hedge strategy that is long (short) the 4% of stocks with the lowest (highest) average analyst recommendation and the lowest (highest) short interest, rebalanced quarterly during 1994-2006, has an average six-month return of +9.6%. The return for this strategy is statistically reliable in all three subperiods, ranging from +6.1% in 1994-1998 to +15.6% in 1999-2003. Most of the value of high short interest as a signal of poor future returns occurs when analyst recommendations are positive.
• A hedge strategy that is long (short) the 4% of stocks with the most positive (negative) average change in analyst recommendation and the lowest (highest) short interest, rebalanced quarterly during 1994-2006, has an average six-month return of +7.9%. The return for this strategy is also statistically reliable in all three subperiods, ranging from +5.9% in 1994-1998 to +10.8% in 1999-2003.

Short sellers with money on the line would seem to be better judges of corporate value than sell side analysts without a monetary stake in the outcome. That shouldn’t be surprising.

The best results are the last two, so let’s concentrate on the practical application of those two.

First, let’s look at the long side:

Low short interest + low average analyst recommendation

Search criteria: Price > $5, % shares short lowest quintile, Consensus Rec. Hold or worse, Analysts coverage > 4 analysts. Results:

• APU
• BGH
• G
• PVG
• EEP
• USM
• CXG
• PVR
• WYE
• OB
• BPL
• CNH
• DUK
• PG
• DD
• DLM
• TNP
• CCE
• LLY
• RAI
• RX
• TKR
• ATO
• CBE
• GIL
• PH
• TSS
• CP
• MMM
• SLE
• SYY
• TRW
• DBD
• TWC
• GE

The more nuanced long strategy: Low short interest + positive analyst change

Search criteria: Price > $5, Analyst consensus rising greater than median, low % shares short, Analyst coverage > 4 analysts. Results:

• DPM
• DK
• GG
• GLW
• CVC
• TE

Now for the short side.

High short interest + high average analyst recommendation.

Search criteria: Price > $5, % shares short high, consensus rec. strong buy or better, analyst coverage 4 analyst or more:

• AMAG
• TRLG
• DGIT
• AIRM
• RAIL
• DLLR
• OPTR
• XRAY
• RCII
• CPRT
• SHOO
• CADX
• ICFI
• OMGI
• RDEA

And the more nuanced short list.

High short interest + negative analyst change.

Search criteria: Price > $5, Analyst consensus falling more than median, High % shares short, Analyst coverage >4 analysts. Results:

• ATPG
• BRNC
• ROCK
• AMWD
• CNLE
• AMSC
• PCBC
• TTWO
• NUVA
• MBLX
• ZUMZ
• COLB
• MDVN
• CGNX
• PTEN

I haven’t done any technical or fundamental analysis of these stocks so this is really just a starting point, but it is certainly an interesting starting point.

The research should disabuse anyone of the notion that Wall Street, sell side analysts are adding any value to the equation. Whether long or short, people with money on the line are better judges of value. And short sellers, who face theoretically infinite loss potential, are particularly good judges of value.