Stock recommendations from analysts or brokerage houses: How valuable are they?

I believe it was Warren Buffet who said “We read analyst reports only if we can’t find the satire pages of the paper”. This saying, while extreme, demonstrates how stock recommendations by brokerage houses are often treated by investment professionals.

Analysts or brokerage houses base their recommendations on research of certain companies and their stocks. More often then not there are more interests at play then meets the eye. This does not mean it is necessarily wrong to act according to these recommendations but you should always have the complete picture before acting.

Take a look at the following facts about brokerage house (or analyst) recommendations:

1) Analyst stock recommendations are always characterized by being quite optimistic. Almost 80% of recommendations are BUY recommendations.
2) An analyst’s BUY recommendation is followed by an incline in the stock’s price and a SELL recommendation by a decline in the stock’s price.
3) Approximately 15% of recommendations are made by financial mediators of various sorts who own a certain percent of the recommended stock. This holds a substantial potential of conflict of interests.
4) Analysts often make recommendations in an untimely fashion - or just too late.

Analyst recommendations are characterized by being too optimistic. Even at times of low trade volumes and strong bearish markets. Only 3%-5% of recommendations are SELL recommendations (The rest are HOLD).

The troubling thing about stock recommendations by brokerage houses is the credibility and influence attributed to them by market players. Market players often attribute knowledge and professionalism to brokerage houses. The question to ask here is: are these working for you and your way?

Market players have a hard time differentiating between brokerage houses and recommendations which have an interest in the stock which is being recommended to others who do not. The affects of recommendations in both instances is quite similar.

Analyst recommendations have been found to cause an incline of around 1.5% in the month following the recommendations. But does this last? Surprisingly, or not, target prices for stocks embody very high returns on these stocks of 10%-30% while actual performance greatly varies with some research showing -3% average performance in three years.

At times, brokerage houses recommendations and analysis does prove itself. A recent example is Goldman-Sachs’s bet against the mortgage market (which others failed to see). These are obviously hard to catch.

What is the value of brokerage house recommendations then? Obviously market players are by no means dumb. The significance attributed to these recommendations by market players has been discussed above. Players are aware of all the shortfalls of analyst recommendations and still allow them to influence their investing, why?

This influence may be attributed to one major factor: Knowledge. Market players often attribute inside information to brokerage houses. These enormous financial bodies have many things going for them:

1) A deep professional understanding of the market
2) Close ties with large corporations and people
3) Intimate knowledge of the companies behind the stocks, at time being responsible for the market offering of these stocks

Due to these factors market players make use of brokerage house recommendations. The use of recommendations may be as guidelines for investing or as a way of affirmation for decisions taken. They do not act solely on analyst recommendations. Affirmation is often achieved by looking for a consensus among analysts or in a strong recommendation by an analyst who has proved himself in the past.

What should you do? Analyze analyst recommendations. Take the time to read analyst reports with a critical eye. You shouldn’t and you don’t have the time write another report all by yourself but you should definitely:

1) Examine the basic major assumptions made by the analyst: Growth in market share, revenues and industry or decline in expenses as a result of technological improvements, scale advantages and more. These assumptions are of critical importance to the final target price set by the analyst. Agreeing on these assumptions is half way to acknowledge the worth of the recommendation
2) Examine the analyst’s treatment of competitors. Do not take the use of multipliers in comparisons lightly. The use of multipliers may be highly misleading
3) Examine the analyst’s treatment of the company’s management.
4) Examine changes from the previous report.

To conclude, as always, one should be a knowledgeable consumer and take analyst recommendations for what they are. One should be knowledgeable of all the shortfalls as well as the strengths and make good, sound use of this tool.