Can Investors Profit from the Prophets? Analyst Recommendations and Stock Returns

Source: Barber, Lehavy, McNichols & Trueman (2001) · The Journal of Finance · DOI: 10.1111/0022-1082.00336

TL;DR

Buying the most-favorably and shorting the least-favorably recommended stocks — with daily rebalancing and a prompt response to recommendation changes — earns >4%/yr gross abnormal returns. But the edge depends entirely on frequent, timely trading: less frequent rebalancing or any delay diminishes it, and once the heavy turnover's transaction costs are netted out, the abnormal net returns are not reliably greater than zero.

What anomaly it documents

Predictor: consensus analyst recommendation level (and changes).

Direction: positive — most-recommended outperform least-recommended (gross).

Shape: monotone across recommendation groups; abnormal gross returns up to ~0.35%/month for the top group; profits require daily rebalancing.

OSAP predictor: ConsRecomm.

How to construct it

Sorting variable: average analyst recommendation (1=strong buy … 5=sell).

Universe: firms with analyst coverage (1985–1996).

Portfolio formation: rank into recommendation groups.

Long / short: long most-favorable, short least-favorable.

Weighting: daily-rebalanced.

Rebalancing: daily (essential to the result).

Evidence and replication

Period	Notes	Source
1985–1996	>4%/yr gross; top-group abnormal up to ~0.35%/mo	this paper
Net of costs	high turnover → abnormal net returns not reliably > 0	this paper
OSAP (ConsRecomm)	replicates gross	Chen & Zimmermann 2022

Why it might work

Information in recommendations: analysts aggregate value-relevant information; prices adjust to changes with a lag.

Limitations and risks

Transaction costs: the gross edge is largely consumed by the required turnover.

Timeliness dependence: delays kill the profits.

Optimism bias: sell-side recommendations skew bullish.

Key references

Barber, B., Lehavy, R., McNichols, M. & Trueman, B. (2001) — Can Investors Profit from the Prophets? — Journal of Finance — DOI: 10.1111/0022-1082.00336

Provenance: verified/generated from the paper's full text.