Cover image for Ahead of the market : the Zacks method for spotting stocks early--in any economy
Ahead of the market : the Zacks method for spotting stocks early--in any economy
Zacks, Mitchell.
Personal Author:
First edition.
Publication Information:
New York : HarperBusiness, [2003]

Physical Description:
xiv, 290 pages : illustrations ; 24 cm
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HG4910 .Z32 2003 Adult Non-Fiction Non-Fiction Area

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Beat the Pros at Their Own Game

All too often, you learn about good stocks far too late to profit from the information. By the time you actually buy a stock, professional investors have already been there, bought the stock, driven up the price, and are just waiting to unload it at an inflated price.

All That's About to Change. . . .

In Ahead of the Market, Mitch Zacks shows investors how they can spot stocks that are poised to take off long before the rest of the crowd learns about them. How? By unlocking the gems of priceless information buried in Wall Street's often self-serving research.

Ahead of the Market is the first book, ever, that enables you to profitably use the analyst stock research for which Wall Street firms pay more than one billion dollars annually. Many investors have rightly felt misled in the past by analysts who continued to hype stocks as prices plummeted. You may have even concluded that Wall Street research is totally worthless. But it's not.

In Ahead of the Market, Mitch Zacks shows that analysts actually provide a wealth of market-moving information that can generate exceptional returns if interpreted correctly.The key is to use the research produced by Wall Street analysts the same way the professional money managers do.

Pioneered by the firm Zacks Investment Research and based on more than twenty years of intensive analysis, the investment strategies revealed in this book are indeed the same ones used by successful professional investors everywhere.

In these pages you will learn how to form an investment plan by locating stocks that are poised for price appreciation and avoiding stocks heading for a fall. Zacks shows how you could have prevented being burned when the recent bubble burst, if you had known how to use analyst research correctly and teaches you the rules of the research game so you will not fall victim the next time around. In sum, this book is your guide to picking the right stock at the right time.

Mitch Zacks's groundbreaking research provides new insights and new strategies to:

Use revisions to analysts' earnings estimates to predict the rise and fall of stock prices Interpret the real meaning behind analysts' stock recommendations Employ the "cockroach" phenomenon and other methodologies to predict earnings surprises before they occur Determine how to react when a company reports earnings and how to profit from "post-earnings announcement drift" Understand and profit from "analyst creep" -- the reason that earnings estimate revisions occur incrementally over time Avoid being duped by the games that companies play with their earnings reports

Whether the economy is healthy or stalled, whether the market is up or down, by focusing on the strategies contained in this book you will always come out ahead. Well-picked individual stocks will always carry the day. Now with Ahead of the Market, you will finally have the same tools institutional investors have and will be able to find great stocks in any market environment.

Reviews 2

Publisher's Weekly Review

Wall Street spends over $1 billion a year analyzing stocks. Too bad much of that analysis is garbage, says author Zacks. He should know: he's v-p of the respected firm Zacks Investment Research, and he's witnessed how the cozy relationship between companies and their investment bankers have corrupted investing over the years. Now he's come out with not only a denunciation of sketchy analysts, but a handbook for individual investors for spotting winning stocks on their own. (A hint: it's all about the earnings estimates; firms whose projected earnings are being revised upwards are the ones to bet on.) Zacks's prose is crisp and swift, and he tackles tricky subjects with dispatch. Sometimes the book veers into an advertisement for the firm and its Web site, but the trove of clear-headed market wisdom is well worth the occasional self-promotion. (Mar. 18) (c) Copyright PWxyz, LLC. All rights reserved

Library Journal Review

Zacks Investment Research is a well-known and widely respected stock investment company which believes that changes in earnings estimates are the best predictor of the direction a stock's value will take. They compare earnings estimates from a wide variety of analysts, average the numbers, select what to buy or sell, and act accordingly. One strength of this book is the clarity with which Zacks, a vice president of the company and frequent TV commentator, compares the advantages and disadvantages of the Zacks system with other investment strategies, such as value investing, long-term, and growth. There are few stories of wise investments or buys gone sour. Instead, numbered lists, key points, tables, and summaries are simply organized for easy understanding of the system. There is a bit more self-advertising in this work than in most volumes on investment methodology, but the system is logical and convincingly presented. A worthwhile purchase for undergraduate and larger public library investment collections.-Patrick J. Brunet, Western Wisconsin Technical Coll. (c) Copyright 2010. Library Journals LLC, a wholly owned subsidiary of Media Source, Inc. No redistribution permitted.



Ahead of the Market The Zacks Method for Spotting Stocks Early -- In Any Economy Chapter One The Main Themes What's ahead in this chapter? Meet the Analyst and His Research Report Analysts and Sell Recommendations Analysts and Buy Recommendations Analysts and Earnings Estimates This book is designed to teach you how to implement several investment strategies that enable you to use the research produced by Wall Street stock analysts profitably. These investment strategies will provide you with independent, time-tested advice and are currently used extensively by professional investors. The strategies are based on over twenty years of research by Zacks into how an investor can most effectively use analyst research. If used correctly, these strategies will generate market-beating returns in both bull and bear markets. The purpose of this first chapter is simple. I want to present you with a basic introduction on how to use analyst research, which became publicly available over the Internet for the first time in the mid-1990s. Meet the Analyst and His Research Report To begin our journey, we must first understand the enigmatic and recently much maligned Wall Street analyst. Yes, analysts suffer from entrenched problems due to the system that they operate in, and yes, analysts are lousy stock pickers; but analysts and the research that they produce can be incredibly useful -- you just need to know how to correctly interpret analysts' research reports and the data that is generated from them. Wall Street brokerage firms collectively employ over 3,000 analysts. These analysts are paid to tell the brokerage firms' customers which stocks to buy and sell. Analysts serve two types of customers: large institutional clients such as mutual funds, pension funds, and hedge funds, and individuals ranging from people saving for their children's education or their personal retirement, to wealthy individuals with several million dollars to invest. Analysts are collectively paid well over $1 billion a year to write research reports explaining their opinions on particular stocks or groups of stocks to the clients of their brokerage firms. These research reports contain a tremendous amount of data, but the two most important components in the research reports are the analysts' recommendations and their earnings estimates. The recommendation refers to whether an analyst thinks you should buy or sell a stock while the earnings estimate is the analyst's prediction of what he thinks a company is going to earn, on a per-share basis, in the next couple of quarters and the next few fiscal years. Up until the mid-1990s, the research reports produced by analysts and the data created from the analysts' reports were, for the most part,not available unless you were a professional investor or had a very large account at a full-service brokerage firm. Today, all the information produced by brokerage firm analysts -- their earnings estimates, their recommendations, and even their research reports -- is available to almost any investor. Unfortunately, most investors are using this newly available information incorrectly and their portfolios are suffering as a result. It Pays to Focus on Earnings Estimates Individual investors seem to be fixated on the most biased parts of analyst research -- the recommendations -- while ignoring the unbiased information that professional investors have been using for years, which is contained in the earnings estimates. In order to use analyst research in the right way you must learn exactly what information produced by analysts you should be focusing on and what information you should be ignoring. The answer is to focus on revisions to analysts' earnings estimates as well as earnings surprises. Let's start by examining the buy/hold/sell recommendations and the earnings per share (EPS) estimates, both of which are contained in an analyst's research report. The Recommendation At the top of every analyst's research report the recommendation is prominently displayed. Recommendations come in a variety of flavors. Each brokerage firm has its own classification of recommendations that its analysts can issue. Some firms have had, at one time, as many as twenty-four possible recommendations that can be issued while other firms have only five possible recommendations that their analysts can issue: "Strong Buy," "Buy," "Hold," "Sell," or "Strong Sell." Beginning in late 2001, many large brokerage firms started to simplify their recommendation classifications in response to the public outcry regarding the lack of sell recommendations industrywide. As a result of these recent changes, most major brokerage firms seem to be migrating toward specifically using "Over-Weight," "Equal-Weight," and "Under-Weight." Most of the major brokerage firms, in addition to issuing a recommendation on a stock, also provide a recommendation on the stock's industry. For instance, Microsoft might receive an "Over-Weight" recommendation and in the same research report, Microsoft's industry of "Computer Software" might receive an "Equal-Weight" recommendation. With three possible recommendations on the stock, and three possible recommendations on the stock's industry, most brokerage firms are moving toward nine possible recommendations available to an analyst. An analyst's recommendation is supposed to boil all his research down into one simple actionable piece of advice, the answer to the question, "Nice ten-page report, but what should I do about the stock?" Not surprisingly, the recommendation is probably the most widely used piece of information contained in the analysts' research reports simply because it is, at face value, easy to understand and appears to be straight-forward. Do not be fooled. An analyst's recommendation is a wolf in sheep's clothing. It is simple. It is straightforward. And invariably it is wrong. In fact, if you had bought those stocks that were the most highly recommended by analysts over the two-and-a-half-year period from April 2000 to September 2002, you would have lost a phenomenal 47%. Key Point Following analysts' recommendations will lead to poor investment performance. Although the recommendation is the most widely used component of the analyst's research report, it should not be -- it is misleading to investors. Analysts and Sell Recommendations One big problem with listening to analysts' recommendations is that analysts have historically been very reluctant to issue sell recommendations. This has been the case since Zacks began tracking analysts' recommendations in the mid-1980s. Today sell recommendations are still uncommon, and this will likely be true in the future even if the various reforms currently being discussed are enacted. Why? Because, as we shall see in the next chapter, the reasons for analysts not issuing sell recommendations are endemic to the system. For now,just accept this: Currently, analysts are collectively over ten times more likely to issue a buy or hold recommendation than a sell recommendation. If you have been following the news, the collective reluctance of analysts to issue sell recommendations should not surprise you. Eliot Spitzer, the attorney general of New York, led an investigation which ended in December of 2002 that brought the dearth of sell recommendations to the public's attention. Since the summer of 2001, analysts have been publicly eviscerated. Jack Grubman has been blamed for the woes of WorldCom, and Henry Blodget was made the fall guy for the Internet bubble. Analysts as a group have been blamed for the "loss of investor confidence" that afflicted the market following the meltdown of technology stocks that began in the first quarter of 2000. The reluctance of analysts to issue sell recommendations has been offered as one reason why individual investors lost a tremendous amount of money. You may have seen pundits and politicians parading themselves on the nightly news indicating that the nefarious analysts are responsible for the infectious greed that brought on the bear market like a fulfillment of biblical prophecy. The Reluctance to Issue Sell Recommendations Is Nothing New Yes, analysts are reluctant to issue sell recommendations, but this is nothing new to the institutional investors who have used analyst research since the dawn of Wall Street. And the whole tech fiasco was not caused by individuals trading stocks online; large institutions bear far more of the blame. The problem is not that analysts are biased; the problem is that no one let individuals in on the secret or told them how to effectively ignore the hype contained in analyst recommendations. Compounding the problem, the Internet gave individuals access to analysts' recommendations and research without the requisite education on how to use the data, so they understandably took analysts' recommendations at face value. When an analyst says "hold," most individuals unfortunately still do not realize that this means "sell," simply because analysts almost never issue negative recommendations. As Spitzer's investigation showed there is an inherent conflict between a brokerage firm's research and its investment banking division. This influences what an analyst is willing to publish in his research reports. Obviously, analysts are reluctant to issue negative research reports on clients of their brokerage firm. Here's why. Investment bankers want to do business with companies -- take them public, help them sell additional shares through secondary offerings, advise them on deals -- and the last thing investment bankers need is one of their firm's research analysts telling the world that the company they want to do business with is a dog. The problem is that high-profile analysts like Jack Grubman compromised the integrity of their research in order to generate investment banking revenue. With WorldCom a voracious acquirer, the argument is that Grubman issued overly optimistic research reports to boost WorldCom's stock price so that WorldCom could make even more acquisitions and generate more fees for his firm. There is definitely some truth to this, but what is not readily known is that even before such conflicts of interest began to appear, analysts always had a bias against issuing negative recommendations. The problem is structural in nature. In fact, the distribution of analyst recommendations has proven to be fairly constant over time. Of the roughly 30,000 individual analyst recommendations that Zacks tracks on over 4,500 individual stocks, currently 8.3% of all analyst recommendations are some form of sell (either a "sell" or "strong sell") and this is the highest the level has been within the last ten years. For most of the past decade, the percentage of all analysts' recommendations that are some form of sell has remained pitifully low. Starting around mid-2001, due to a combination of the bear market (analysts are more likely to issue sell recommendations in a bear market) and the political pressures being placed on analysts to issue more sell recommendations, there has been a slight increase in the number of sell recommendations. However, despite these pressures and a string of slick new ads for brokerage firms in which they herald the independence of their analysts, I would not expect the distribution of analysts' recommendations to change dramatically in the coming months and years. If the distribution does change I would expect the change to be temporary. Why? Because once analysts and their recommendations fade from the regulatory spotlight, brokerage firms, as we shall see, will always have everything to lose but nothing to gain by issuing a "sell" recommendation. Key Point Regardless of the structural changes made, analysts will continue to be reluctant to issue sell recommendations. This reluctance is endemic to the system. In addition, analysts' recommendations move markets. As long as this is the case, analysts' recommendations will likely be manipulated or at least influenced by investment bankers. Analysts and Buy Recommendations So, waiting for an analyst to flat-out tell you to sell a stock is a modern-day financial version of Waiting for Godot. Still, you may be wondering whether analysts' buy recommendations can make you money. This question will be examined thoroughly later on, but for now let's skip to the chase: The answer, unfortunately, is "not readily." The simplest way to see this is to look at the performance of what are called "brokerage firm buy lists." Brokerage Firm Buy Lists Most brokerage firms create a "buy list" or "core list" that generally comprises anywhere between fifteen and thirty stocks representing a well-balanced portfolio of the firm's top stock picks taken from all the analysts working at the firm. Some firms even offer their buy lists as an actual portfolio that investors can invest in. These buy lists are thus usually screened for diversification concerns to ensure the entire list is a reasonable portfolio that can be bought in its entirety. At Zacks we have been tracking the performance of every brokerage firm's buy list for over ten years, and their performance is not as exceptional as you might be led to believe. The results for fifteen large brokerage firms are given in Figure 1-1. Ever since we have been monitoring the performance of brokerage firms' buy lists, over almost any period examined, roughly half of the brokerage firm buy lists beat the S&P 500 and half of the brokerage firm buy lists under-perform the S&P 500. In other words, the best picks of the top analysts at the top brokerage firms are no better than those selected by the typical mutual fund manager, which also under-perform the S&P 500 about half of the time. The moral is clear: Analysts and the data they produce may be good for many things, but telling you when to buy or sell is definitely not one of them. You need to rely on other information. Key Point Analysts are not exceptional stock pickers. This is apparent when you investigate the returns of the buy lists created by brokerage firms. Although you can not easily use an analyst's recommendation to tell you when to buy and sell a stock, the analysts do produce a piece of information that will help you: their earnings estimates. Because a company actually reports earnings each and every quarter, analysts' earnings estimates are tied to reality and are less subjective in nature. As a result, analysts' earnings estimates are far more pure than analysts' recommendations. Key Point Focus on analysts' earnings estimates rather than their recommendations because the earnings estimates are less subjective and thus contain more information for the investor. Importance of Predicting Analysts' Behavior The best way to use analyst research is to try to anticipate what an analyst is going to do in the future instead of simply responding to the information contained in an individual analyst's research report. You need to understand the distinction. At the most basic level, the recommendation contained in an individual analyst's research report is likely to already be reflected in the price of a stock -- especially if the research report is more than a month or two old. If a Morgan Stanley analyst issues a recommendation saying that buying General Electric (GE) stock at current levels is the best opportunity the analyst has seen in the last decade, GE's stock price is going to almost immediately soar to reflect this information. Invariably, by the time you act on what is in the analyst's research report, it will be too late. GE's stock will have already made its move. You want to buy -- in the case of upgrades -- or sell -- in the case of downgrades -- before the analyst issues his recommendation change, not after. This is relatively hard to do with recommendation changes, but as we shall see later on, it can be done; stocks for which multiple analysts have upgraded their recommendations tend to exhibit strength over the next month, while stocks for which multiple analysts have downgraded their recommendations tend to exhibit weakness over the next month. We will address this in Chapter Ten when I discuss a statistic called the consensus recommendation score. While it is difficult to predict whether an analyst will upgrade or downgrade a stock, it is far easier to anticipate if an analyst will change his earnings estimates. By buying stocks whose earnings estimates have recently been revised upward and selling stocks whose earnings estimates have been revised downward, you can effectively anticipate the future actions of both analysts and the large institutional investors whose behavior moves stock prices. This enables you to be able to buy or sell a stock "ahead of the market." Key PoinT By combining the research produced by multiple analysts and looking for changes over time in the revisions to analysts' earnings estimates, you can predict what analysts will likely do in the future. Analysts and Earnings Estimates There is a whole chapter in this book (Chapter 4) devoted to why analysts' earnings estimates are one of the most important determinants of a stock's price. But, for now, I want to explain how you can find stocks for which analysts are raising their earnings estimates. These are the stocks you should be buying. In order to determine which stocks are receiving upward earnings estimate revisions from analysts, you need to condense all the earnings estimates issued by all the analysts following a stock into a statistic called the consensus earnings estimate. The next step is to then track changes to the consensus earnings estimate over time and buy stocks for which the consensus earnings estimate is increasing over time. A consensus earnings estimate sounds rather exotic but in reality is rather mundane. The consensus earnings estimate is simply the average value of all the earnings estimates issued by all the analysts following a specific stock. Here's how we determine it at Zacks. Right below the recommendation in an analyst's research report are the analyst's earnings estimates. These earnings estimates are what the analyst feels the company he is covering is going to report in earnings on a per share basis in the coming quarters and the coming and next fiscal year. To create the consensus earnings estimate, we take the earnings estimates issued by all the analysts following a stock and average them. In Figure 1-2 is a sample of the research Zacks provides to, which is available free to anyone who has access to the Internet. (To find several websites that contain the following data or similar data, please see Appendix III.) All the data that is in bold is consensus data. That list of brokers at the end of the report is the list of brokers from which the consensus data is calculated. Look at section A in Figure 1-2. This section shows the current consensus earnings estimate for Sears (S). At the time this page was printed off of the Internet, eight analysts were issuing earnings estimates for Sears for the coming quarter. Of these eight analysts, their earnings estimates ranged from a low of $1.97 to a high of $2.12, with an average, or consensus, of $2.06. Armed with that information, you should then employ a strategy that is well known to professional investors: Look for changes to the consensus earnings estimate over time. To do this, identify section B of the report, labeled "Analyst Estimates Trend." In this case we note that for Sears, the consensus earnings estimate for the current and next fiscal year has decreased over the past thirty days. This means that over the last month, some of the analysts have lowered their earnings estimates for Sears. This is a bearish sign and indicates that Sears should be avoided in the immediate future because other analysts will likely be lowering their earnings estimatesand, additionally, the market will take some time in reacting to the already lowered earnings estimates. Key Point The simplest and best way to use analyst research is to focus on revisions to analysts' earnings estimates. An excellent way to accomplish this is to watch for changes to the consensus earnings estimate over time. Does Focusing on Analysts' Earnings Estimates Actually Work? Of the roughly 9,000 U.S. stocks that you could buy through a discount brokerage account, about 3,300 of them have a market capitalization of more than $100 million and also have at least one analyst who follows the stock and issues earnings estimates. 1 To see the effect of tracking changes in the consensus, each and every month let's divide the 3,300 largest stocks into roughly five portfolios, each containing an equal number of stocks based on the degree to which analysts have revised their earnings estimates over the past month. We'll call the first portfolio the "Earnings Estimates Slashed" portfolio. This portfolio contains the 660 stocks for which the consensus earnings estimate decreased by the greatest percentage over the last month. The fact that the consensus earnings estimate decreased over the past months means that some if not all of the analysts following the company lowered their earnings estimates over the past month. In order to be in the "Earnings Estimates Slashed" portfolio, a stock's consensus earnings estimate must have decreased by greater than 3% over the past month. Let's call the fifth portfolio the "Earnings Estimates Dramatically Raised" portfolio. This portfolio contains those 660 stocks that had the highest percent change in the consensus earnings estimate over the last month. These are the stocks for which analysts raised their earnings estimates; thus the consensus earnings estimate increased. Over the full time period, in order to be in the "Earnings Estimates Dramatically Raised" portfolio, a stock's consensus earnings estimate must have increased, on average, by greater than 1% over the past month. This value is lower than what was necessary to be included in the "Earnings Estimates Slashed" portfolio because large negative earnings estimate revisions are more common than large positive earnings estimate revisions. If we put an equal amount of money into each portfolio and track the returns each month, what do we find? Well, if we track the performance of these portfolios over the fifteen years from October 1987 through September 2002, what we discover is that the "Earnings Estimates Slashed" portfolio fell at an annualized rate of 4.2% over the full time period. On the other hand, the "Earnings Estimates Dramatically Raised" portfolio rose at an annualized average rate of 20.1% over the full time period. The annualized returns of the five portfolios are given in Figure 1-3. These annualized returns do not factor in transaction costs or commissions; if you are not careful, you may go broke from the huge commissions due to the high turnover in your portfolio. Nevertheless, the results are quite compelling. What we see is that stocks that are receiving upward earnings estimate revisions tend to increase in value over the next month, while stocks receiving downward estimate revisions tend to be weak over the next month. Key Point Changes in the consensus earnings estimate are a far stronger signal of future price movement than analysts' buy/hold/sell recommendations. How do you put all this information to work for you? It is clear that you should do the following: Buy stocks that are receiving upward earnings estimate revisions. Buy stocks whose consensus recommendation score has substantially increased over the past month. (We will see more proof of this later on.) Sell stocks that are receiving downward earnings estimate revisions. Sell stocks whose consensus recommendation score has decreased substantially over the past month. All of this makes it sound as if interpreting analysts' data is a bit of an art -- and it is. I will show you how to use analyst research profitably in the next several chapters, paying particular attention to revisions to analysts' earnings estimates, earnings surprises and changes in analysts' recommendations. Summary: Analysts are biased in their recommendations and are not exceptional stock pickers. You should, for the most part, never use analysts' recommendations to tell you when to buy or sell a stock. In order to use analyst research effectively, it is necessary to combine the research from multiple analysts and focus on how this combined data changes over time. By doing this, you can anticipate analyst activity and determine which analyst actions will result in a price response that lasts over a period of time. The piece of combined data that is the most important to focus on is revisions to analysts' earnings estimates. Revisions to analysts' earnings estimates are reflected in changes to the consensus earnings estimate over time. Thus you want to buy stocks for which the consensus earnings estimate is increasing and sell stocks for which the consensus earnings estimate is decreasing. Endnotes The database used for all the studies in the book has been adjusted to remove any survivorship or look-ahead bias. What this means is that in the studies it is possible to buy any stock even if the stock later goes bankrupt or is acquired -- the database does not consist of only surviving companies. Ahead of the Market The Zacks Method for Spotting Stocks Early -- In Any Economy . Copyright © by Mitch Zacks. Reprinted by permission of HarperCollins Publishers, Inc. All rights reserved. Available now wherever books are sold. Excerpted from Ahead of the Market: The Zacks Method for Spotting Stocks Early - In Any Economy by Mitchel Zacks All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.

Table of Contents

Acknowledgementsp. vi
Introductionp. vii
Chapter 1 The Main Themesp. 1
Chapter 2 How the Analyst Got His Biasp. 18
Chapter 3 Dissecting the Analyst's Reportp. 39
Chapter 4 The Importance of Earnings and Earnings Estimate Revisionsp. 59
Chapter 5 How to Use Earnings Estimates to Pick Stocks Profitablyp. 84
Chapter 6 The Earnings Surprisep. 109
Chapter 7 Using the Earnings Surprise in Your Investment Processp. 129
Chapter 8 It All Comes Together--The Zacks Rank: The Key to Successful Investingp. 146
Chapter 9 Effectively Implementing the Zacks Rankp. 164
Chapter 10 How to Effectively Use Analysts' Recommendationsp. 185
Chapter 11 Analyst Neglect and Long-Term Earnings Growth Estimatesp. 207
Chapter 12 Valuation, Earnings Uncertainty, and the Fed Modelp. 225
Conclusionp. 244
Appendix I Free Subscription to zacksadvisor.comp. 252
Appendix II Overview of the Zacks Snapshot Reportp. 256
Appendix III Where to Find Analyst-Related Researchp. 262
Appendix IV A Dow Strategy Based on Expected Earnings Uncertaintyp. 278
Indexp. 283