Cowen Research Report: Ignore Equity Analysts in Terms of Biotech Stocks

Analyst Report

Cowen Research’s biotech team published a recent report and concluded that investors would have better luck ignoring—or even doing the complete opposite—of what equity analysts advise.

“We have analyzed the value of sell-side ratings, and whether following them is associated with investment returns,” the analysts wrote in their report. “Unfortunately (for our job security and sense of self-worth), we find that over the last four years there was an overall inverse correlation between sell-side ratings and rating changes and the performance of biotechnology stock.”

For example, whenever a stock’s rating has dropped a step, say from “buy” to “hold,” it correlated with a 22 percent increase in price, the report said. And, to add insult to injury, the bigger the change in rating, the less the sell-side analyst’s opinion mattered.

Biotech investing is notoriously volatile, but it can also create huge returns. For example, a $1000 investment in Gilead Sciences at its initial public offering in January 1992, by 2015, that investment would have been worth more than $100,000. The Nasdaq Biotechnology Index has shown a 450 percent return since 2009.

The Cowen analysts evaluated 30 companies in the Nasdaq Biotechnology Index that at least 10 analysts covered during a four-year period and compared the stocks’ performance from 2015 through June 15 to their recommendations at the end of the previous year to get their results.

Bloomberg writes, “Whenever there was a change toward a strong buy rating on a company, the worse the prognosis for shares. Rating trending toward a strong sell performed better. Equity analysts are also heavily weighted toward buy ratings and don’t tend to change their views much despite market volatility and shifting investors sentiment, says [Phil] Nadeau [Cowen senior research analyst]. Nadeau himself rates 35 companies—with 27 of those buys, six holds and no sells—according to Bloomberg data.”

The Cowen report offered three possible explanations. First, that stock ratings are reactionary instead of predictive. Second, that “stock picking is not job #1,” and that “management access, collecting data points, maintaining models, and talking with investors take up time and distract from determining ratings.” And third, stock ratings reflect investor consensus, which generally underperforms.

Experienced investors understand that no one gets it right all the time and that anything short-term is going to be a gamble. But there’s an entire industry built on that gamble.

Some of that volatility and unpredictability related to early-stage biotech companies is also likely due to investing in companies that don’t have products for sale, typically have no revenue, and the business model is often predicated on getting to proof-of-concept in early-stage clinical trials and being acquired by a bigger company or developing partnerships or licensing deals. There are a lot of variables there.

Les Funtleyder, a portfolio manager at E Squared Capital Management and a former sell-side analyst, told CNBC he wasn’t surprised by the Cowen report. “The sell-side across all industries has had difficulties getting things right per almost all academic research. Among other things, they tend to have positive bias because they are selling.”

Also, he went on to say, it’s not limited to biotech or health. Those industries, though, tend to be more complicated than in other industries, and as a result, investors often rely on specialists in that space.

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