Understanding the Investment Value of SumZero Research

This short piece clarifies our findings from our analysis of the recommendations submitted to SumZero.com. Various financial commentators have made misleading and confusing statements regarding our research and we would like to set the record straight.

In the most recent version of a paper entitled (3), “The Investment Value of Contrarian Buy-Side Recommendations,” by Steve Crawford, Wesley R. Gray, Bryan Johnson, and Richard Price, we examine a comprehensive set of investment recommendations paired with analyst-specific information from over 1,000 buy-side analysts (predominantly analysts from hedge funds) from the private website SumZero.com (4). We summarize the key results below.

Empirical Finding #1: Recommendations Earn Abnormal Returns
Recommendations from SumZero.com analysts generate abnormal returns when the reports are posted to the website, and the returns drift in the direction of the recommendation in the months following the recommendation. Abnormal returns are concentrated in smaller firms; recommendations on larger securities earn positive abnormal returns, but the results are statistically insignificant. Returns are the most dramatic for contrarian recommendations (i.e., those issued contrary to the sell-side consensus), demonstrating that the research posted to SumZero is most valuable when it includes analysis that sets it apart from the research produced by sell-side analysts employed by investment banks and brokerages. These results are consistent with SumZero’s stated objective of generating unique research that is unencumbered by the conflicts of interest that can influence the research produced by sell-side analysts.

Empirical Finding #2: Evidence for “Talking Your Book” and not “Pump and Dump”
In addition to documenting abnormal returns after the reports are posted on SumZero, we show that contrarian recommendations returns trend in the direction of the recommendation in the two weeks prior to when they are available on SumZero. These “pre” returns suggest that buy-side firms are taking positions in the stocks their analysts recommend prior to the reports’ appearance on the website. While this result suggests the buy-side firms are “front-running” their recommendations, returns in the months following the recommendation do not reverse, indicating that SumZero analysts are not engaged in “pump and dump” behavior. Furthermore, we also document that buy-side firms increase their holdings in stocks their analysts recommend on SumZero in periods extending two quarters beyond the recommendation date. Taken together, the results suggest that buy-side professionals use SumZero to effectively “talk their book” and generate gains for themselves and other buy-side firms with access to SumZero research (a win-win relationship).

Empirical Finding #3: There is a wealth transfer between the Broad Institutional Investor Universe (Predominently Mutual Funds) and SumZero-affiliated Firms
We find that aggregate institutional holdings decline after the issuance of a SumZero recommendation (institutional investors are selling) and that the stocks being sold by the broad institutional market (bought by the SumZero counterparties) are small, illiquid firms. When combined with the abnormal return analysis, which shows SumZero recommendations earning their highest outperformance on the most illiquid and small stock recommendations, the holdings data provide evidence that wealth transfers are taking place between SumZero investors and the rest of the institutional marketplace. In economic terms, SumZero investors are effectively receiving a payment (in the form of abnormal returns) for liquidity provision and information discovery.

Correspondence:
Wesley R. Gray, Ph.D.
Email: wes@empiritrage.com
Web: http://www.empiritrage.com
SSRN: http://papers.ssrn.com/sol3/cf_dev/AbsByAuth.cfm?per_id=432318
Link to Full Paper

__________________
Footnotes:
(1) Wes is a coauthor on an academic paper that studies SumZero.com recommendations: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1971533
(2) The author(s) of this research have not received financial support from SumZero or their affiliates. The research was conducted in accordance with the policy on objectivity in research for Drexel University, Rice University, Creighton University, and Utah State University.
(3) The most recent edition is as of October 27, 2013. The first version was December 14, 2011.
(4) This paper was previously circulated under the title of “Do Buy-Side Recommendations have Investment Value.”