How to use stockbrokers’ reports on buy or sell recommendations

Brokerages, who make enormous investments in collecting, analysing and publishing research for consumption by the investment community, often use the reports as a value addition tool to boost their businesses.

However, persistent evidence shows that most broker recommendations exhibit a poor track record of picking stocks. In this article, I attempt to identify the conflict of interest and challenges faced by research analysts and how ordinary investors can make use of research reports.

To start with, forecasting stock returns a year or two in advance is exceedingly difficult. Often, failing to foresee one big event such as this year’s rapid weakening of the shilling can render research reports completely useless.

Of course, research analysts try to do better by using complex models to forecast currency rates, earnings growth, price/earnings ratios and other market-driving factors.

However, despite the effort put into the exercise, forecasting the stock market is extremely difficult, if not impossible. For this reason, rather than invest based on research report recommendations, most investors are better off sticking with their usual allocations and, for planning purpose, to assume that stocks over the long run will rise at their usual pace.

Secondly, most broker recommendations have historically exhibited a ‘buy’ bias. This is because most sell-side research analysts who work for brokerage houses which often have strong investment banking franchises create a potential conflict of interest when their employers act as investment bankers to the companies they cover.

A common practice is for equity analysts to initiate coverage of a company in order to develop relationships that lead to highly profitable investment banking business.

Thirdly, analysts are also subject to the behavioural bias known as “herding” in the sense that they release recommendations that are seemingly highly correlated.

Lastly, the way brokerage houses are compensated creates a need to advise clients to trade frequently.

Brokers are paid via trading commissions based on transactions and so, the more transactions, the more money they make. Therefore, it’s possible such an inclination filters through their reports to get clients to trade more frequently than necessary.

So how does one make use of research reports? The best way to use broker research is to focus on what seems to add value. Investors ought to give more weight to changes in recommendations rather than the recommendations themselves.

They should also focus on using the research to understand the overall industry and the current operating environment.

In other words, investors are better off focusing on the educational value of these reports as opposed to their advisory value.

Moreover, investors ought to recognise that broker reports are used for a multitude of purposes and in particular, to make money for the firm producing them.