Investment analysts who follow a company’s suppliers and customers produce notably more accurate forecasts – and make considerably more money for investors that follow their recommendations -- than analysts who focus on groups of companies in the same industry, according to new research out of Temple University in Philadelphia and Southern Illinois University in Carbondale.
The study looked at the track records for 2,645 analysts who covered an average six companies each, creating more than 16,000 forecasting records. It found that “vertical specialists” – the supplier and customer followers -- consistently outperformed sector specialists, regardless of analyst expertise or experience, or the type of company studied.
Investors who followed recommendations from vertical specialists generated an average one-year return of 10.9% on their investments, compared to returns of 1.72% for those that followed sector analysts, according to the study. Vertical strategists also produced forecasts that were 2.9 times more accurate and six times more consistent than those from industry analysts, according to the report.
The findings run counter to conventional wisdom in the brokerage world, where most investment houses take a sector-based approach to equities research. Analysts usually are assigned to follow solely companies that compete with each other, rather than companies that interact. Analysts assigned to cover Hanesbrands (HBI), for example, also follow clothes maker VF (VFC) and PVH (PVH) because they make competing products. Another analyst team follows the cotton suppliers, and yet another follows the retailers that ultimately sell its products. In that scenario, a sector analyst is responsible for a universe that looks like this:
NYSE:VFC data by YCharts
Responsibilities for a VFC vertical analyst would include whatever company or data point he could unearth that interacts with VFC, as well as some competitors. That might be a more obscure connection like Averitt Express, a private trucking company that delivers a lot of its product, as well as the retailers like Target (TGT) and commodities like cotton.
NYSE:VFC data by YCharts
Sector specialization seemed counterintuitive to Mihir Mehta, assistant professor of accounting at Temple’s Fox School of Business. “If an Apple (AAPL) supplier says it’s selling more chips, then that’s more relevant information than how many Kindles Amazon (AMZN) sold,” he said. (YCharts recently noted the advantage of following Cirrus Logic, CRUS, a supplier of audio chips to Apple, for clues about Apple’s future plans.) Mehta authored the study with David Reeb, professor of accounting and finance at Temple, and Wanli Zhao, assistant professor of finance at Southern Illinois.
The study found that the advantages of vertical research were most pronounced in highly innovative industries. But forecasts from vertical specialists were at least as good as those of traditional analysts in all industries, and often better. The results imply that investors can get a clearer picture of Caterpillar’s (CAT), for example, by studying trends at ActivePower (ACPW) than Deere & Co. (DE). ActivePower sells Caterpillar uninterruptible power sources; Deere is a direct competitor. Caterpillar supplied about 12% of ActivePower’s total revenue last year, so ActivePower’s trends often reflect strength and weakness in of certain Caterpillar units.
For most investment researchers, the biggest hurdle to vertical analysis is identifying the pertinent suppliers and distributors to follow. PepsiCo’s (PEP) “key suppliers” may be giant companies in which Pepsi business is hidden under the sales of many other big customers. Most of those partners will not be so reliant on Pepsi for sales that they have to spell out the details of that relationship in its regulatory filings. But for investment results that are six times better? That would certainly make the extra financial research worth the effort.
Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at email@example.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.