He likes a trade on FX and indices, but is a little scared of those volatile commodities. That doesn’t stop a dabble now and again, but he certainly keeps the deeds to the house in the back pocket when Brent Crude is involved.
This silly zebu can’t decide whether he prefers fundamental or technical analysis, so often makes “technically fundamental” trades. As long as both sides are saying to go the same way, lump on and hope for the best!
Understanding Broker Recommendations
In recent years, the influence of broker recommendations has increased immensely. Wall Street firms employ thousands of analysts whose sole job is to issue recommendations (aka tips or advice or ratings) on specific companies. Share prices have been known to jump significantly after an influential analyst marks a stock as a buy. A sell recommendation could knock 5% off a company’s value. So let’s find out what these broker recommendations are all about and how we can use them.
What Are Broker Recommendations?
In coming up with a recommendations, the first thing that the broker/analyst does is attempt to put a value on the company. He typically builds financial models in order to project company fundamentals and expected future earnings. What the broker comes up with is what he thinks the share should be trading at.
If the value that he comes up with is higher than the price the share is trading at, then he would rate the company as a buy. If the value is lower, then he usually rates the company as a sell. Sounds simple enough and it should be. But as this is the world of high and complicated finance, broker recommendations get (needlessly) more complicated than that.
Broker Recommendations Terminology
It would be nice if every broker just issued buy, hold or sell recommendations. However each investment company has its own terminology, which can make it difficult to compare broker recommendations. Not to worry, we can still group the different lingo used into three categories:
- Buy
- Hold
- Sell
Includes: Buy, Strong Buy, Outperform, Moderate Buy, Accumulate, Overweight, Add, Market Perform
These recommendations indicate that the analyst likes the company. They’re not necessarily an outright tip to buy the share, but instead are an indication that the broker thinks the company will outperform its sector or index. While these are the company’s that you want to be going long on, be aware that buy recommendations are as common as rain in Dublin.
Includes: Hold, Neutral, Inline, Equalweight
These are pretty boring neutral recommendations. Nothing particularly exciting is going to be happening to these companies in the next while. If you’re not already in a trade on one of these companies, just ignore them. Plenty more fish in the sea.
Includes: Sell, Strong Sell, Underperform, Moderate Sell, Weak Hold, Underweight, Reduce
The opposite of a buy recommendation, these tips indicate that if you are considering shorting a company in a sector, then this may be a good one to sell. These companies are likely to underperform.
Recommendation Upgrades And Downgrades
Nothing is static in this fast moving world. Very frequently, the highly paid, dapper brokers change their mind on particular companies. They can upgrade their recommendations to a higher rating or downgrade them to a lower standing. Depending on how influential the analyst is, that change in recommendation can significantly influence the company’s share price. An upgrade (e.g. from hold to buy) tends to send the share price higher, while a downgrade (e.g. from hold to sell) tends to send it lower.
Let’s say that Frankie Rich had a buy rating on Rapid Technologies with a price target of €10.50. But then Frankie runs the numbers again with a few different variables and decides that Rapid Technologies is now only worth €6.50 a share. That’s a pretty significant change and Frankie is going to have to downgrade his recommendation on the company. Depending on how influential Frankie is, that could cause the share price to fall 10% or even more.
Twice a day, paddypowertrader publishes a list of changes in broker recommendations to keep you in the loop.
Do These Tips Actually Work?
An analyst’s recommendation is certainly a better tip than what you’d get from a taxi driver or your sister-in-law’s neighbour, but you should view them with a healthy dose of reality. They probably won’t make you a millionaire. Throughout history, plenty of buy rated companies have seen their share price plummet.
Ideally you wouldn’t trade solely on the back of a broker recommendation. Instead, use them to confirm your own research and company picking. If you find a company that you want to trade and you see that some broker is going the same way as you, you’re on the right track.
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March 15th, 2010 at 4:45 pm
An article by the FT’s Lex column today on “Analyst recommendations”
http://www.ft.com/cms/s/3/97b42200-2f8b-11df-9153-00144feabdc0.html
The “buy” and “sell” recommendations issued by research analysts on traded stocks are a constant source of stress for chief executives. Perceived as being market movers, the highest-ranked researchers take home million-dollar pay-packets, demand a chief executive’s full attention, and rarely bother to offer their advice to outsiders, unless they happen to be a big client of the bank.
For these reasons, securities regulators require strict Chinese walls between research departments and trading floors. But for all the fuss, how powerful are they as a driver of a stock’s performance?
Research by hedge fund GLG, which tracked share price movements before and after broker announcements, does show a connection between recommendations and a stock’s subsequent performance.
It found that when an average stock burdened with a consensus “sell” recommendation is given a “buy” rating, the underperforming price turns round and, after 100 days, the stock can be expected to outperform the market by about 2 per cent. And when a large broker issues the recommendation, the effect is almost half as much again.
For example, K+S, the German chemical maker and previously a consensus “sell”, was upgraded to “buy” in January by Bank of America Merrill Lynch and its share price jumped 12 per cent. Of course, many other factors influence share prices, but on average this effect is repeated.
Proving causality, though, is difficult. Typically, a broker issues a recommendation immediately after the company announces news such as earnings figures or a landmark acquisition. It is almost impossible to determine how much of the subsequent share price movement is due to the broker’s advice and how much would have occurred anyway based on the news. This does not negate the purpose of analysts, but reminds chief executives to take care before assuming they control their company’s destiny.