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The Handbook of Equity Market Anomalies: Translating Market Inefficiencies into Effective Investment Strategies by Leonard Zacks

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Chapter 3

The Analyst Recommendation and Earnings Forecast Anomaly

George Serafeim

Someof the first anomalies discovered that contradicted the theory of an efficient market were related to the information provided by analysts. Analyst related anomalies violate the semi strong market efficiency hypothesis if analyst recommendations and earnings forecasts can be used to predict future prices. This is because analyst recommendations and forecasts are publicly available information and, as a result, anyone can trade on this information soon after its release. A review of the evidence of profitable investment strategies that exploit analysts’ output is provided. The results show that investment opportunities exist for a subset of stocks and analysts. However, transaction costs are a formidable impediment that investors should take into account when they consider the profitability of these strategies.

Role of Research Analysts

Information is a critical element of a well-functioning market. Accumulating information allows an individual to make a better decision and potentially trade a certain asset at a more favorable price. Therefore, investors spend considerable amounts of money to buy analysis from information intermediaries such as security analysts. In 2006, U.S. and U.K. investment firms spent $7.1 billion on sell-side research (Tabb Group 2006).

Because of the magnitude of the economic resources that are spent on security analysis there is considerable debate about the value that ...

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