When to Follow Analysts

This isn't fiction. There's solid research behind these conclusions, published in top academic journals and based on transaction records. I've written regularly about these shoot-yourself-in-the-foot tendencies. After all, you can't learn from your mistakes unless you know what they are.

But this month I'm offering up good news. New research makes little guys look considerably smarter. One Harvard study points out that the top tier of individual investors are remarkably adept traders. Better, perhaps, than some pros. Another study indicates that individuals consistently do well when they own shares in companies based close to where they live.

In what follows, I'll provide the details behind these studies and suggestions about how to put them to use. I'll also update you on another academic insight that seems to have real value. Last year I had some of my best-ever results (annual returns of more than 30% in a declining market) with a portfolio of companies chosen solely because analysts agree about their prospects. I'll explain the logic of this strategy and offer a new roster of potential winners.

By way of background, the unpleasant truths in my initial paragraph are based on work done by Terry Odean, who teaches at Berkeley's Haas School of Business. As a Ph.D. student in the '90s, Odean scored a once-in-a-lifetime coup. He wangled two sets of customer data (70,000 accounts without customer names, nearly a decade of trading history) from a big discount broker — unidentified, but generally assumed to be Charles Schwab.

With some heavy number crunching, Odean confirmed much of what had been only theory about how psychology affects markets. Among his findings: Overconfidence causes people to trade too often, and loss aversion keeps them from unloading their dogs. Odean quickly became a star in the new field of behavioral finance.

Like most academics, he believes that index funds are the smartest way to invest-one reason, perhaps, that brokers have become reluctant to provide more trading records for further research. Why encourage customers to take their business elsewhere? Other economists, however, are using Odean's data to test new theories. No one questions his conclusions, but there is now evidence that small investors aren't always boobs.

Even though individuals trail the market on average, some people consistently make money. Joshua Coval at Harvard, David Hirshleifer at Ohio State and Tyler Shumway at the University of Michigan evaluated nearly 17,000 accounts with 25 or more trades between 1990 and 1996. They ranked the group based on overall performance and discovered that the top 10% beat the market by a wide margin, better than 10 percentage points annually.

What's more impressive is statistical evidence of "hot hands." Traders with a string of successes seemed more likely to be successful in the future. Coval and his colleagues wonder: What do the big winners have in common? Is there a learning curve? Answers, unfortunately, will have to wait until brokerages share more data.

Another study, conducted by Zoran Ivkovich and Scott Weisbenner at the University of Illinois, looked at what economists call "local bias." Tracking more than 30,000 accounts, they found that hometown stocks are significantly overrepresented in individual portfolios — composing 30% of total assets. No surprise perhaps. But the local preference seems to be based on information, not just familiarity. Local holdings outperform nonlocal investments by nearly four percentage points annually. Far more if you focus on companies that aren't in the S&P 500.

The message? Own what you know — and pay close attention if you have insight into small companies where analyst coverage is skimpy and the flow of information is inefficient. Did the plant add a shift? Are employees happy? Is the warehouse a mess? Those may be clues that can make you a better investor. Another insight: The worst-performing individual holdings by far were small nonlocal stocks. Avoid hot tips about remote low-profile companies.

Now for this month's table, based on research about analysts instead of individuals. In December 2001 ("Don't Sell 'Em Short"), I wrote about the fact that stocks perform better when there's broad agreement over earnings estimates (something called low estimate dispersion). There are two reasons this might affect prices. Theory No. 1 involves management. Companies with nothing to hide communicate more clearly. But when there's trouble ahead, the message from management tends to be cloudy rather than outright negative, so analyst estimates are more scattered. Theory No. 2 relates to the inherent difficulties of selling short and the restraining effect of dispersion on short sellers. The more investors disagree, the more likely unrestrained optimists will push prices too high.

Complicated, yes. But you don't need to understand the theory to appreciate its results. Harvard's Anna Scherbina recently published a key dispersion paper in the Journal of Finance — her thesis from Northwestern, where she was a graduate student when I interviewed her for my earlier column. The screen I created to replicate Scherbina's work is up more than 35% with only one loser. Elementary back-testing shows similar performance for portfolios constructed every three months over the past two years.

I'm trying this one again. I looked first at companies with more than two earnings estimates for the next two fiscal years. Then I ranked stocks according to the standard deviation of estimates (a measure of disagreement). I also wanted analysts to have a track record of accuracy, so I compared last year's actual results with the consensus estimate. About 50 stocks ranked in the top 20% based on all three yardsticks. I narrowed that list by looking at the companies analysts like best. I also focused on small stocks (market values between $500 million and $1.5 billion), where analysts can add significant value.

The eight companies in the table are attractive because, on average, they're nearly 50% more profitable than the median S&P company, and — measured in terms of price/earnings ratios divided by growth rates — you often can buy their earnings growth for far less. Also, several are leaders in niche markets.

Charles River, long known for its profitable lab rat business (150 varieties), now gets over half its revenue from other, faster-growing areas of biomedical research. Corporate Executive Board offers subscription-based research for big companies. With $225 million in cash and securities, 65% gross margins and a 25% growth rate, it's worth listening to. Donaldson, meanwhile, sells specialized filtration systems — for everything from aircraft cabins to PC disk drives to industrial turbines. And Education Management will teach you to draw or cook or design clothes at its Art Institutes. It has 40,000 students and 29 campuses nationwide.

FNB is a regional bank with a difference. It operates in Ohio, Pennsylvania and Florida, where it is steadily expanding. Current yield is 3.1%, with 30 years of annual dividend increases. Heartland is a one-of-a-kind trucker: No debt, $3 per share in cash and 12% margins — the industry's best. Respironics makes devices to treat sleep and breathing disorders, a home-care market. It has a promising new product, plus an underappreciated hospital business. Finally, there's restaurant chain Ruby Tuesday. It is growing nearly as fast as competitors Applebee's and Brinker, with less advertising. Ruby's shares are cheaper, too.