It’s an interesting question. Stock brokers are very professional, they’re highly qualified and have years of experience. They work for broking houses that usually have an army of research analysts and economists that work together and produce quality content for their clients. Unfortunately though, it’s not as clear cut or as easy as it seems. There are biases that sometimes prevent brokers and broking houses from being brutally honest. Firstly let’s look at research reports. They are usually labelled as either buy, sell or hold. But what you often find is that brokers use Underperform, Outperform as well as Neutral and they all have very different meanings. Below is a chart from Investopedia that shows the ranking of stock recommendations from Sell (bearish) to Buy (bullish). Buy is usually a recommendation to purchase a stock. Sell is a recommendation to sell a stock. Pretty straight forward. Hold is the expectation that the stock will perform at the same pace as comparable companies or in-line with the market. You can also expect to see Underperform which means the stock is expected to do slightly worse than the market return and Outperform which means the stock is expected to do slightly better than the market return.
Where things get a bit challenging is when each broker has its own definition for recommendations. For example Deutsche Bank will use a “Buy” recommendation and it means to purchase a stock whereas Ord Minnett will use Buy and it means that a stock’s total return will exceed 20%. See how they’re both very different. Here are a few broker recommendations and their meanings:
- Credit Suisse – Outperform >=7.5%. Neutral -5%-15.0%. Underperform =<5.0%.
- Deutsche Bank – Buy: Recommend that investors buy the stock. Sell: Recommend that investors sell the stock. Hold: Do not recommend either a Buy or Sell.
- Morgans – Add – The current credit spread and yield of the security compare favourably to peer securities and offers an attractive total return for new investors. Hold – The security’s current pricing reflects fair value relative to peer securities. Reduce – The current credit spread and yield looks expensive relative to peer securities. Holders should consider alternative securities.
- Ord Minnett – Speculative Buy – The stocks total return to exceed 20% over 12 months. Buy – The stock’s total return is expected to exceed 15% over the next 12 months. Accumulate – Total return of between 5% and 15%. Hold – The stock to return between 0% and 5% and believe the stock is fairly priced. Lighten – Expect the stock’s return to be between 0% and negative 15%. Investors should consider decreasing their holdings. Sell – Expect the total return to lose 15% or more.
- UBS – Buy Forecast Stock Return is > 6% above the Market Return Assumption. Neutral is between -6% and 6% of the MRA. Sell FSR is >6% below the MRA.
- Bell Potter – Buy: Expect >15% total return on a 12 month view. For stocks regarded as ‘Speculative’ a return of >30% is expected. Hold: Expect total return between -5% and 15% on a 12 month view Sell: Expect <-5% total return on a 12 month view.
- Shaw & Partners – Buy Expected to outperform the overall market. Hold Expected to perform in line with the overall market. Sell Expected to underperform the overall market.
- Macquarie – Outperform – return >3% in excess of benchmark return. Neutral – return within 3% of benchmark return. Underperform – return >3% below benchmark return.
- Morgan Stanley – Overweight (O). The stock’s total return is expected to exceed the average total return of the analyst’s industry coverage universe over the next 12-18 months. Equal-weight (E). The stock’s total return is expected to be in line with the average total return of the analyst’s industry coverage universe. Underweight (U). The stock’s total return is expected to be below the average total return of the analyst’s industry (or industry team’s) coverage universe.
- Citi – Ratings are a function of analyst expectations of expected total return (ETR) and risk. Buy – ETR of 15% or more or 25% or more for High risk stocks and Sell for negative ETR. Neutral if an analyst believes that there are insufficient valuation drivers to derive a positive or negative investment view.
Being an ex-stockbroker, I’ve gained valuable insight into the inner workings of a broking house and its operations. Each broking house had a research department filled with a legion of analysts that worked day and night to produce research reports on ASX listed companies. It also had a corporate team that managed M&A activity, equity raisings and IPO’s. Naturally a broking firm earns big money from winning corporate deals, so research reports are always biased towards companies it had corporate undertakings with. What you need to keep in mind is that most stockbroking houses write research reports tailored to institutional investors and not the regular punter. So most reports were biased and conservative.
Here are a few reasons not to trust broker recommendations:
- Recommendations are usually bullish on companies it has corporate dealings. It’s plainly obvious why. If the broking house recently conducted a capital raising for a company, you can guarantee it will always have a bullish write up despite the downside. This is to keep the company happy and ensure it continues to do business going forward.
- Analysts are always behind the eight ball. Research reports tend to lag the share price because analysts will refrain from predicting the future. They hate to get it wrong, so instead they tend to be safe rather than sorry. Research has become more reactive. When a company issues a profit downgrade, it will be followed by broker downgrades as analysts readjust their earnings forecasts after the event. Analysts won’t try and predict a profit downgrade.
- Target prices are rubbish. Analysts will use the discount cash flow method to produce a target price on a company. These target prices should be taken with a grain of salt. It’s best to avoid becoming too reliant on this method that is the value of a stock being related to the present value of the future stream of free cash flow. DCF can be difficult to apply in real-world scenarios especially with mining stocks that are reliant on commodity prices. Valuations based on commodity price assumptions always tend to be wrong because commodity prices are volatile. Analysts also use the EV/EBITDA ratio. The problem is target prices always change, depending on the outlook for a company’s earnings.
- Brokers will never have a Sell until it’s too late. For a stockbroker to place a Sell on a stock, is usually a rare occurrence. The moment a broking firm rates a stock a Sell, the relationship with the company is tarnished. You can kiss any future corporate deals goodbye. This is the reason you won’t see a Sell recommendation on RIO or BHP. A broker will only put a Sell on a stock if it’s plainly obvious or if other brokers have done so. Otherwise the broker will downgrade to a Hold.
- A Hold is a Sell. For reasons mentioned above, brokers will sometimes refrain from putting a Sell on a stock and will substitute it with a Hold recommendation.
- Biases – The individual analyst covering the stock could have a wide range of biases that can tend to sway his recommendation. Analysts will also use a varied bunch of fundamentalists, technical, quant and a mixture of the three plus more obscure methodologies to come to their conclusion. There is no universal method of valuing a company.
- Sector bias – An analyst will be designated a specific sector such as a tech analyst, industrial analyst or bank analyst. Analyst’s assess sector trends, prepare forecasts, and develop industry models according to that sector only. Therefore their job is to pick the best performing stocks in their specific sector and issue a Buy rating accordingly even if the entire sector is in the dooldrums.
Here is an example of a stockbroker that has been biased on a particular stock and has rode it all the way down and kept its Buy rating. Here are broker reports on Newcrest Mining (NCM) since 2010.
- 16 August 2011 – Citi – BUY – $44 target price. Current Share price $38.70
- 26 April 2012 – Citi – BUY – Target cut to 3200c from 3800c. Current Share price $17.05.
- On the 30 June 2012 the share price fell all the way down to $22.61.
- 11 June 2013 –Citi – SELL – Target price of 1100c. $12.03
- 26 July 2013 – Citi – SELL – Target price of 900c. $12.41
- On the 30 June 2013 the share price had fallen all the way back to $9.87.
- 18 August 2015 – Citi – BUY – Target price of 1510c. $11.44.
So you can see from the above example just how wrong Citi were in their recommendation and target price. Back August in 2011 the broker had a Buy recommendation with a target price of $42.00, the current price was $38.70. Newcrest Mining shares fell all the way back to $12.03 before Citi decided to put a Sell on the stock. That’s a 71% loss had you followed Citi’s recommendation and Sold on the 11 June 2013. Ouch. So for that reason we advise investors not to take broker recommendations and target prices too seriously. Instead pay more attention to broker upgrades. When a broker upgrades a stock, it’s usually on the back of a catalyst which brings about higher earnings going forward. This is more of a bullish buy indicator than a target price. On the same note, look out for downgrades. They usually occur after an event and earning usually fall going forward. Capital raisings – Pay attention to disclosures. When a stockbroking firm has undertaken a capital raising or the IPO, the report will be biased. The bottom line, brokers often have conflicts of interest and sometimes simply get it wrong. Don’t rely on one broker recommendation, use all of them to form your own opinion. Treat a broker report as part of a bigger picture and not the only source of research for your investment decision. One thing to remember is that no one can predict the future, no matter who they are.