This is a common sight in the stock market: A prominent brokerage firm (usually from a huge global bank) issues a glowing research report on a company, and the company’s share price goes on a tear, perhaps even rising by 20% to 30% within a day. This phenomenon is also observed when smaller brokerages issue chunky initiation reports on a company that may be under the radar or not so well-covered.
So, does it make sense for investors to rely on a broker’s recommendation and buy the stock that is being promoted?
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The underlying motivation
First of all, let us examine the motivation behind broker reports, and who they are disseminated to. Brokerage firms and banks hire a team of investment analysts that is headed by a Chief Investment Officer; such teams regularly meet companies and churn out reports which discuss the companies’ merits and risks.
Most reports are tagged with a “target price” or “fair value,” usually with a time horizon of one year, and the analyst writing the report will also provide opinions on why investors should buy the company’s shares. Some of these reports are fairly comprehensive, with details on a company’s business model, financial metrics and ratios, catalysts, growth plans, and risks. The analyst would then value the company using financial models and arrive at a fair value, which is usually above the current share price, thus making the case for investors to invest in the company’s shares.
Note that the brokerage reports are usually first issued to the clients of the brokerage firms and banks, as the clients are the ones who have priority. The general public usually receives the reports later through various means – websites and mailing lists, for example. By the time the information arrives in the hands of the retail investor, it has probably been through many rounds of investors who had first-hand access to the information and were thus able to take advantage of it to buy much earlier.
So I can detect two main problems here. Firstly, the fact that the information provided is “free” and that everyone has access to it means that there is no informational advantage, and that all the positive information relating to such reports would be priced in. The second problem is that almost all these reports encourage short-term thinking as their price targets are for 12 months only.
Around 85% of all analyst reports also have “Buy” ratings, versus 10% for “Hold” ratings and just 5% for “Sell” ratings. This implies that the entire brokerage industry is biased positively towards companies and are reluctant to issue any other opinion. There are reasons for the bias which I shall detail in a subsequent article, but it should be clear by now that brokerage reports are not as reliable as they seem. Investors should read them for the wealth of data and information they do provide, but should stop short when it comes to acting on the advice and recommendations given.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.