Academic journal article Journal of Economics and Finance

Schwab's Equity Ratings: Value Added or Old News?

Academic journal article Journal of Economics and Finance

Schwab's Equity Ratings: Value Added or Old News?

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Formed in 1973, Charles Schwab and Company, Incorporated (hereafter, Schwab) is arguably one of the more successful brokerage firms in the world. Among their many services, Schwab's Center for Financial Research provides Equity Ratings that rank stocks from "A" to "F" and they boast a very impressive track record of returns. From their website, their "A" rated stocks are reported to have outperformed their "F" rated stocks by about 14 % including dividends over all weekly overlapping 52-week periods since May 2002. However, the reported results do not control for well-known variables that explain stock returns, thereby providing the motivation for this study. More specifically, this study aims to examine whether Schwab's equity ratings methodology explains stock returns beyond known explanatory variables.

Schwab's equity ratings appear to be overlooked in the literature and are an interesting dataset to study because their system incorporates well-known variables from academic research into their analysis. Moreover and unlike many other services, Schwab issues an equal (or mostly equal) number of "sell" ratings as "buy" ratings.1 So using data for the year 2014, this study examines in real-time whether the conclusions from Schwab's Center for Financial Research as communicated via their stock rating system adds explanatory value to returns beyond well-known and accepted variables from the literature. Using both parametric tests and nonparametric analyses, the evidence suggests that Schwab's ex-ante stock ratings do appear to add explanatory value to ex-post stock returns beyond known drivers of returns. The strongest model is a 4-factor model consisting of Schwab's equity percentile rankings, together with firm Beta, firm size and a stock's nearness to its 52-week high.

1Stock rating services and Schwab's equity ratings system2

One of the earliest rating services to be studied in the academic literature was Value Line, a service that has been widely examined in the literature. For example, Holloway and Clark (1981) attempts to settle the then ongoing debate about the usefulness of the service. He shows that an active trading strategy does not outperform when transaction costs are considered, but argues that a buy-and-hold strategy based on Value Line's recommendations does outperform, even after transaction costs. More recently, Szakmary et al. (2008) test the longer-term Value Line projections for stock returns. They find that previously documented abnormal returns can be associated with either well-known anomalies or data mining. And of course, the most well-known and most-studied service is probably the Morningstar ratings of mutual fund performance. A plethora of studies have examined Morningstar, such as Blake and Morey (2000) who study the rating system to determine if they predict future fund performance for U.S. equity funds. They find no compelling evidence of significant outperformance.

Some newspapers such as the Investor's Business Daily and the USA Today also provide stock ratings. Olson et al. (1998) test the stock ranking system of the Investor's Business Daily newspaper and find that abnormal returns do result from using this system. However, abnormal returns are smaller for the second half of the data set than the first. Atkinson and Sturm (2003) study the ex-post performance of mutual funds identified by the newspaper USA Today as "all-star" funds for the year 1997. They find that as a group, the 25 funds identified as "all-stars" do not outperform and that less than half of the funds potentially (but not conclusively) outperform.

More recently and from other media and Internet outlets, Lim and Rosario (2010) analyze the performance of stocks picked by Jim Cramer on his television program "Mad Money" and find some evidence of outperformance for small-capitalized stocks. Giacomino and Akers (2011) provide an overview of the investment research service, The Motley Fool, finding that their claims are probably overstated. …

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