A 'Collected Wisdom' apprenticeship

Here's what I've learnt about broker research.

Summary: Our Collected Wisdom column compiles consensus views from analysts on a variety of stocks, but it’s important to understand where this information comes from and how it is compiled. Research out of major broking houses tends to focus mostly on large cap stocks, and while price targets and buy/hold/sell calls are useful starting points, investors should not use them as the definitive guide to their investments

Key take out: It’s important to view broker research in context and know that without talking to the analyst who compiled a report, you won’t be getting a full picture of the stock covered.

Key beneficiaries: General investors. Category: Shares.

After writing Collected Wisdom for six months now, there are a few ideas I thought I would share for you to ponder over the break. Collected Wisdom is our weekly compilation of consensus analyst views on large market cap stocks that are topical at the time. I look for stocks with recent news flow or announcements that materially change the outlook for the business.

The analysts come from the larger research broking houses. These companies have the resources to send analysts around the country visiting companies, with each analyst having responsibility over designated sectors. This is equity research that a full-fee paying brokerage client would receive.

With that in mind, it’s worth considering the motives behind the research. Broking houses make money from the amount of brokerage they write buying and selling stocks for clients. They also have a corporate division (of capital raisings etc.) that can be highly profitable, and important to the overall business. They play an important role in the market for individual retail investors, large fund managers and corporate clients alike. I am not going to downplay the ability of the analysts, as the larger brokerage houses have the deepest pockets and generally attract some of the best talent.

Given the different revenue arms of a broking house, it does mean the equity research analyst can be conflicted on certain occasions. For example, what is in the best interests for large fund managers, may not be in the best interests of the firm’s retail clients. The types of stocks the “corporate department” want the analyst to cover may not actually be the companies that have the best chance of achieving share price growth.

Size matters

As with any commercial operation, stock broking businesses will focus their strategy on what they believe will give them the best chance of achieving optimal profitability. This means equity research is directed towards companies that are large enough and have adequate liquidity for both retail and institutional clients to trade in those stocks. For example, a stock with a market cap of less than $200 million is often not likely to have the liquidity required for the firm to make enough money from its clients trading in and out of the stock. This is an example of where a stock analyst can be conflicted. They may have found a stock that they think will triple and make money for retail clients. However, if it is not likely to achieve the required brokerage, then often the firm will prevent the research analyst from covering that stock. Instead this analyst may have to pick a larger stock with less potential for say, a 10 per cent capital gain, but with far greater brokerage prospects for the firm.

If following their research alone, you will be pushed more towards the larger end of the market, which is highly competitive. With so many analysts researching the same stocks, as an individual investor you will not have much of a competitive edge here. It is interesting to note a large number of companies covered by the Eureka Growth First model portfolio and even the Income portfolio are not covered or covered by very few analysts. You will not find research papers on them. A large number of the LICs I cover who specialise in small to mid-cap stocks, and you won’t find much analyst coverage on their holdings.

So if you are looking for the highest growth stories, you unfortunately often won’t find them from broking research houses.  The growth stories that can be found from these analysts tend to be turnaround value or cyclical plays. There’s also a focus on larger stocks that are out of favour with the market – right now, this would be the likes of Woolworths, BHP or RIO. You will occasionally get the real growth stories like CSL or Blackmores, but large cap stocks that can grow at the rate those two have are few and far between. Talking about value/cyclical plays brings us on to another topic – consensus views.

Safety in numbers

When I write Collected Wisdom I look for the consensus view and it is generally easy to find it. The bulk of the price targets/valuations from analysts will tend to be in a percent or two of each other. You don’t typically see too many outliers either on the bullish or bearish side of things. It is safer to be wrong with everyone else than right on your own.

There is another side to this as well, because some analysts will try to stand out on calls to make a name for themselves, and occasionally go too far one way or the other. There’s a saying that tips are worth what you pay for them and buy, hold and sell calls are no different.

Another saying rings true here: there’s no such thing as a free lunch. If you are reading these reports without any sort of context, don’t think you are going to be getting the full story. You will not receive the same treatment a full fee paying client of a broker would receive. They will spend time talking to their valuable clients because they are keeping the lights on.

What we try to do with Collected Wisdom is show you the positive side of the story and the risks attached. The investor needs to give more thought to their decisions than just reading a few paragraphs and then acting.

Price targets & what they mean             

Price targets need to be taken with a grain of salt. They are not valuations and they will vary as new information comes to light as will valuations. Additionally, they can be watered down, for example only showing the stock with a 10 per cent upside when analysts really believe it has a 30 per cent upside. Once again someone who is paying large amounts in brokerage will get the full story and more than what a report can say. As they should, they are paying top dollar for it.

In summary what I have seen reading through these reports is you need to understand them in context. Realise who they are originally written for and the source they are coming from. The stocks need to be big enough for institutional clients to buy into. Without talking to the analyst who has written the piece, it is unlikely that you will be getting the same amount of knowledge as the firm’s priority retail and institutional clients.

I approach Collected Wisdom each week with the aim to show the upside potential and the risks as well and showing the middle ground, high ground and lower levels of the price targets. If you are considering the “buy” calls as a potential purchase it is always, best to view these reports as the starting point rather than the end of your research process.

At the end of the day as a self-directed investor it is your money. You make the ultimate investment call and it is you who needs to live with the results. I am going to do my best to point out what the news really means for these large caps, but a “buy”, “hold” or a “sell” call is not the end of the story.