Zacks Slips Up

Zacks, a respected equity research house and fund manager with a stellar track record for performance, recommended on December 28th buying Chipotle Mexican Grill shares, which have since fallen more than 26% value in only 7 trading days.

Here’s their admittedly short recommendation:

“Aggressive Growth – Chipotle Mexican Grill, Inc. (NYSE: CMG) Chipotle Mexican Grill is serving up spicy earnings. Its latest quarter registered 75% earnings growth as more customers visited its burrito restaurants. Same-store sales grew at an awesome 12.5% rate during the quarter. This year’s earnings estimates have increased 13 cents to $2.15 per share over the past 60 days. Analysts expect over 27% growth next year in earnings.”

Now, because this only covers two weeks’ as a sample, it’s not entirely representative of Zacks and their overall record. However, this buy call on CMG shows the downfall of buying what Zacks calls”Aggressive Growth”. Being valued into the stratosphere and approaching the sun, it’s easy for the wax holding your wings together to melt.

Let’s learn more about the Zacks Rank:

“Since 1988, the Zacks Rank has proven that “Earnings estimate revisions are the most powerful force impacting stock prices.” Since inception in 1988, #1 Rank stocks have generated an average annual return of +32.2%. During the 2000-2002 bear market, Zacks #1 Rank stocks gained +43.8%, while the S&P 500 tumbled -37.6%. Also note that the Zacks Rank system has just as many Strong Sell recommendations (Rank #5) as Strong Buy recommendations (Rank #1). Since 1988, Zacks Rank #5 stocks have underperformed the S&P 500 by 129% annually (+5.3% vs. +12.1%). Thus, the Zacks Rank system allows investors to truly manage portfolio trading effectively.”

Sounds impressive. Let’s see how they got their numbers:

“The performance of the Zacks Rank portfolios shown above for annual and year-to-date periods [...] assume monthly rebalancing and zero transaction costs. These are not the returns of actual portfolios.”

Wow. Zero transation costs. How genius! Zacks’ modeling of real portfolios is just SO accurate, because everybody knows that trading stocks is free! Wait-

So Zacks assumes monthly rebalancing to come up with these theoretical returns. Monthly rebalancing is great as a risk management tool. It scoops up your gains monthly, limiting downside exposure to high-flying growth stocks, and scoops up more value by doubling-down on positions that have lost money. However, this increases your turnover and your transaction costs, which are-SURPRISE!-not even taken into consideration by Zacks.

They’d have more credibility if they modeled their portfolio’s historical/theoretical return with conservative average transaction costs for each period. Obviously, transaction costs have gone down since 1988, but they’d make a very big difference on the final results, especially when adjusting for the compounding of the transaction costs on performance.

I wish everyone were that straightforward, but it appears Zacks is more interested in getting attention and generating buzz than being honest about their theoretical historical returns.

Zacks Buy List Highlights: Chipotle Mexican Grill, Joy Global, Mechel OAO and AVX Corporation