There’s an old joke about stockbrokers that goes something like this:
Client: What do you think of stock XYZ?
Broker: Are you buying or selling?
This exchange highlights something investors tend to overlook – that as long as brokers are getting their clients to buy or sell, they’re making money. As long as the client is doing something rather than nothing, they’re happy. You won’t find many brokers agreeing with Warren Buffett's assertion that his ideal holding period is forever.
Broker research isn’t designed to identify long-term value because its fundamental purpose is to encourage you to trade. This also explains why recommendations are very short term in nature, allowing a stock to be a Sell one year, a Buy the next, and a Sell again six months later, without any significant change in valuation.
- There are inherent conflicts of interest in broking research
- Ignore broking recommendations; they’re too short term
- Use it for company insights, industry perspectives and cross-checking
While the economic rationale for this flip-flopping is obvious, the terms used to hide it can be mind-bendingly complex. Check out the fine print from one broker:
‘Overweight, Equal-weight … and Underweight are not the equivalent of buy, hold and sell’. Rather, ‘Overweight’ for example, means ‘the stock’s total return is expected to exceed the average total return of the analyst’s industry (or industry team’s) coverage universe, on a risk-adjusted basis, over the next 12-18 months.’
Got that? Such an explanation could result in a Buy recommendation with a negative expected return. At a different broker, a ‘Sell’ is assigned if the stock’s expected total return (price appreciation plus dividend yield) is negative. A non-dividend paying stock could be saddled with a ‘Sell’ if the price is expected to fall by just 1% over the next year.
So whilst a long-term investor might buy XYZ because he expects it to generate, say, a total return of 70% over five years, his broker could consider it perfectly reasonable to sell the same stock because he expects it to be steady over the next 12 months.
This difference in time horizon is part of the reason why broking analysts and long-term investors – including Intelligent Investor Share Advisor – often have conflicting recommendations on the same stock.
So how do broking analysts derive recommendations based on such short time horizons? Here’s where the ‘price target’ comes in. Long-term investors don’t really care what a stock’s price might be in a year. Actually, they do care; they just don't think it's possible to predict such short-term movements with any degree of consistency. Instead, they reason that value and price must ultimately converge, so buying at a decent discount to value should see them right.
Because broking analysts don’t have the luxury of time, they try to guess where the price might be in 12 months, with a focus on ‘catalysts’ that might get the price moving. They’ll then justify the price target with an alarmingly precise valuation.
Occasionally, they’ll even admit the price target has little to do with the valuation. In fact part of the problem with this approach is that it tends to distract you from the search for value. Take this example from broking research on Computershare in August 2011 (since when the stock has climbed 76% to $12.23):
‘Computershare … now offers clear absolute value [at $6.95]. This is illustrated by … our 12-month roll-forward valuation of A$9.30.’ But Computershare ‘lacks its usual catalysts’ and ‘Reflecting this, we lower our target price to A$7.50 … setting this at a significant discount to our valuation’ and ‘maintain HOLD’.
There’s another problem, too. Most broking firms have investment banking arms that advise companies on corporate transactions, capital raisings and the like. One rarely reads critical research because, not only would it reduce the chance of winning investment banking business, management might refuse to speak to that broker’s analyst in future.
What is it good for?
So if broking research is next to useless for recommendations, valuations and long-term investing, what is it good for?
First, broking analysts usually know companies and their business models pretty well. They speak to management and competitors regularly, constructing detailed models and forecasts – sometimes of doubtful value – with the information they collect. Fund managers will happily admit to using broking research for its insights and detail whilst paying no attention to the recommendations.
|Do use broking research for:|
|- Detailed company and business model insights|
|- Competitor and industry analysis and broader perspectives|
|- Potential contrarian indicators (a result of its short-term focus)|
|- Cross-checking historical numbers and your own numerical analysis|
|Don’t use broking research for:|
|- Long-term investing (it’s not designed for it)|
|- Recommendations (brokers are too short term)|
|- Valuations (they’re implausibly precise)|
Second, broking firms usually produce detailed industry analysis that can offer useful industry perspectives, although it invariably focuses on short-term issues within a company or industry, while skipping over the drivers of long-term success (or failure). Still, as long as you use it with care, such research can be useful.
Third, broking research’s short-term focus can make it a useful contrarian indicator. Broking analysts have their fingers on the market pulse, so their research tends to reflect the prevailing mood. As we’ve seen, broking analysts don’t issue ‘Sell’ recommendations lightly so a negative recommendation might highlight a very unloved stock. If nothing else, broker ‘Sell’ recommendations can help you make the bear case.
Fourth, broking research can help with the numerical side of your analysis. Use it to cross-check historical numbers from company accounts, or check your own estimates against forecasts. For example, if you estimate a company’s prospective free cash flow at $100m a year and a broking analyst think it'll only be $50m, you should investigate why. As long as you ignore the valuation and recommendation, this kind of checking can be very useful.
So how do you gain access to broking research? All you need to do is ask, although you may need to direct some commission towards the broking firm you have in mind. But please, don’t tell them any stockbroker jokes, or mention this article.