5 Stocks Experts Like

Last night I read an article that polled the most renowned music experts on the greatest music albums of all time. The list of the top 5 includes Rubber Soul, Sgt. Pepper's Lonely Hearts Club Band and Revolver by the Beatles, Highway 61 Revisited by Bob Dylan, and Marvin Gaye's What’s Going On. (I have to admit, the Beach Boys actually made the experts' top 5, but this is my article and I'm vetoing them. They're OK, but a top 5 album?) Looking at the list, I would have to say that although they aren't my personal top 5, these are some pretty damn good albums.

So on my train ride into work this morning, I thought about those music experts and their strong consensus picks and wondered if expert stock analysts could provide insights or other information that would lead to strong, profitable stock picks. On first thought, you'd think since all this analyst information is highly public, that it's already priced into the stocks and you can’t profit from it. But, herein lies a market anomaly. Let's take a closer look.

Stock analysts provide many different types of data on companies from buy/hold/sell recommendations to earnings estimates to projected growth rates. I tested all this information to see if you can beat the market with it.

Beginning with a universe of the largest 3000 stocks, I ran tests from January 2000 until June 2011 by building portfolios based on each of these analyst metrics. The average annualized return and standard deviation are below:

The above results show that four of these measures outperformed the selection universe and three underperformed. It's interesting to note that the analyst ratings in and of themselves didn't perform better than the selection universe, but the change in analyst ratings did extremely well. So don't just buy a "Strong Buy" because it's a "Strong Buy." It's better to buy a "Strong Buy" that moved from something else (like a "Sell" or "Hold") to a "Strong Buy."

These results also indicate that a company with a high 3-5 year projected growth rate is something that should be shunned like the plague. As you can see, high expected growth usually ends badly. Excluding those companies with expected growth rates above 20%, the returns improve dramatically (10.8% versus -3.5%). Remember this the next time you hear someone hawking a stock with projected growth rates above 20%!

Based on the performance figures above, here's a method for finding stocks to take advantage of the Analyst Anomaly:

• First, create a liquid, investible set of the stocks with the largest 3000 market values and average daily trading volume greater than or equal to 100,000 shares (if there's not enough liquidity, it'll be hard for you to trade).
  
• Next, due to the uncertainty regarding some foreign issues, keep only U.S. common stocks.
  
• Add another filter by selecting the top 100 stocks with the highest percentage change in the average rating over the last four weeks. (You want improved consensus ratings.)
  
• Then select only those top 50 stocks with the highest net revision (up minus down) over the last four weeks. (You want to maximize the number of upgrades and minimize the number of downgrades.)
  
• Of these 50, pick 25 with the largest percentage increase in the last four weeks of the current quarter's earnings estimate. (Improving quarterly earnings estimates is good.)
  
• Finally, select the top 10 stocks with the highest percentage increase of the last four weeks in the current quarter's earnings estimate. (Improving annual earnings estimates is good too.)

Here are 5 great stocks based on analyst data (09/15/11):

COF - Analyst Report – Capital One Financial Corp.

Capital One is a bank holding company that gathers deposits and makes loans. Over the last month, analysts have upgraded the stock to Outperform and increased both their quarterly and annual earnings estimates.

IP - Analyst Report – International Paper Co.

International Paper operates as a paper and packaging company with worldwide operations. Analysts we surveyed have been upgrading ratings and earnings estimates for this company, which pays a nice dividend too.

NDAQ - Analyst Report – The NASDAQ OMX Group, Inc.

Another company with worldwide operations, NASDAQ provides trading, clearing, exchange technology, and securities listing services. A few analysts have upgraded their opinion for this company, but of particular interest is the number increasing their earnings estimates.

PRIM - Snapshot Report – Primoris Services Corporation

Primoris, a specialty contractor and infrastructure company, provides a range of construction, fabrication, maintenance, replacement, water and wastewater, and product engineering services. Analysts like this company and have been increasing their earnings estimates due to Primoris receiving many new contracts. Last month, the company also increased its dividend.

HURN - Snapshot Report – Huron Consulting Group Inc.

Huron provides operational and financial consulting services in the US. Last month, analysts upgraded this firm to "Buy" from "Neutral". Earnings estimates have also been increased due to strong demand for the services this company provides.

To conclude, this article presents examples of how you can use pieces of information provided by analysts to beat the market. But just remember, don't believe everything analysts say. Use your own discretion to evaluate what's meaningful and what's not. Everyone has different tastes, so be aware of that.

In case you were wondering, my personal list of top 5 albums ever produced includes: the Beatles' Sgt. Pepper, Dylan's Highway 61, Gaye's What’s Going On, The Clash's London Calling and The Sun Sessions by Elvis. Although it doesn't discuss music, there is a website that discusses various types of stock market anomalies and how you can profit by them. Please visit hema.zacks.com and "profit on!"

Read the full analyst report on IP

Read the full analyst report on PRIM

Read the full analyst report on COF

Read the full analyst report on NDAQ

Read the full analyst report on HURN