Understanding analyst research, who writes it and what it tells you
Over the past 15 years, DIY investors have enjoyed some notable improvements in the availability of market data and sophisticated execution capabilities. But while the tools to make investment decisions have got better, one issue that continues to divide opinion is the usefulness & availability of analyst research.
Most investors are familiar with the ‘buy’ and ‘sell’ recommendations from City analysts that routinely crop up in the financial press. Journalists feast on these signals without necessarily giving them much thought or context, and bulletin boards buzz about their meaning. But the detailed research behind these recommendations is often either hidden away or leaves the investor wondering about its reliability, accuracy and value.
In this mini-series of articles we are going to explore some of the reasons why analyst research is both loved and loathed by investors and whether trading off recommendations it a viable strategy. We will also show you how you can profit from analyst research by using the tricks, tools and screens available at Stockopedia to get a new insight into what it really means.
Who writes this stuff?
If the stockmarket is an engine and information is the oil then analysts are best thought of as the mechanics. They may not enjoy the glamour or compensation of the traders and investors who drive the car, but without analysts the engine would soon grind to a halt. When Richard Wyckoff wrote Studies in Ticker Tape Reading back in 1910, he not only introduced the world to the science of market analysis but he also kicked off increasing academic and professional interest in how markets and companies can and should be analysed.
Since then the role of the analyst has become more defined and more influential – but has also come under major scrutiny from regulators and academics. Research notes are routinely produced on the day of company results (final and interim), trading updates and major news. Analysts enjoy special access to management teams when discussing events, forecasts and in the development of their financial models, which means that their insight and opinions ought to be of interest to any investor, although often it is restricted to a privileged few.
Who is research produced for?
Market players – from investment banks to boutique brokers – employ analysts to cover companies, advise clients and ultimately encourage them to trade shares. But structural problems in a sometimes myopic market mean that the information and insight they produce doesn’t get to everyone. Unless you are a client of the firm in question, getting your hands on the research notes of the best analysts can be a challenge. Often this information is only designed for the eyes of institutions that pay fees or offer fixed-commission business, with disclaimers and restrictions stemming the flow to a broader base of recipients. This situation led the United States to introduce Regulation Fair Disclosure back in 2000 to ensure that sell-side analysts were not getting access to special information from management which is not available to the market at large.
On this side of the pond, things are lamentably much further behind. However, the emergence of independent research houses, which often charge companies for coverage, has tried to open the door to a great deal more independent analysis. This work is distributed for free and is therefore more widely accessible by individual investors. The London Stock Exchange has encouraged this type of fee-based research, particularly for smaller companies, as a means of improving visibility and liquidity. Smaller companies often don’t attract mainstream research beyond what a house broker might produce, which can be a deterrent to both institutions and individuals that might otherwise want to invest. As a result, fee-based research has flourished, though the impartiality of the research produced under these arrangements should be questioned.
How reliable are the opinions?
While the selective dissemination of research is a bugbear of information-hungry investors, it isn’t the only criticism of analyst coverage. Over the past ten years regulators and academics have scrutinised the independence of analyst forecasts, their accuracy and how predictive they really are. An interesting observation here is that there is a weight of evidence that analysts issue far more ‘buy’ recommendations than they do ‘sells’. This is believed to be the case because a bullish stance encourages trading and makes corporate clients happy even though it might not necessarily reflect the reality of the fundamentals.
Changes have been made in the way analyst notes are presented, such as clarifying the relationships between the company and the broker, but many believe that a lot of research can still be biased and of varying quality. In some instances, it’s claimed, research notes can turn out to be at best just a rehash of company news rather than thoughtful analysis or, at worst, a biased siren song ahead of impending calamity.
In large and mid-cap stocks, the credibility of analyst research is likely to be improved by the number of analysts covering the stocks. Usually, multiple analysts from a broad range of banks and brokers will put out notes, making it easier to identify divergence from what’s known as the ‘consensus’ view. At this higher end, the concerns tend to focus on whether there is any movement of information between Chinese walls inside investment banks and the pressures that an analyst might feel if, say, his firm also provides corporate finance advice, investment banking or even brokerage services to the company. Some observers suggest that analysts from the house broker will be among the most conservative of all the analysts tracking a company, perhaps with a view to letting the company beat forecasts – and hopefully seeing its share price rise as a result.
Further down the scale, the research supporting smaller, less liquid companies presents different issues. AIM companies can, and often do, hire Nominated Advisers (the buffer between the company and the stock exchange) that also act as brokers. This doubling-up means that it’s possible for the only research on the company to have come from a firm that already has strong fee-based links to it, which again gives rise to concerns about potential conflicts. The emergence of independent research boutiques that charge companies for research services have partially resolved this problem but, again, critics point to the potential for influence in research that the company itself has paid for.
Is following analysts an investment strategy worth considering?
There have been numerous academic studies into the quality and the predictive nature (or otherwise) of analyst research – with very mixed results. As we will discuss later, work by David Dreman and James Montier has shown that it's important not to be too swayed by the opinions of these so-called "experts" as their forecasting track record is generally not good. Still, one of the largest UK studies was carried out in 1984 by Dimson and Marsh from the LondonBusinessSchool. They examined 4,000 stock return forecasts for 200 of the largest UK shares provided by 35 different firms of brokers and analysts. They found that analysis did indeed provide a ‘small but potentially useful degree of forecasting ability’. But they also concluded that a large part of the information content in the forecasts was quickly discounted in the market place within the first month.
For individual investors, keeping track of what analysts are saying about stocks is virtually impossible without access to top quality data and the tools to use it. At Stockopedia, our Stock Reports include details of the analysts covering a particular company, the consensus broker recommendation and the trend in the consensus forecast over recent months. This information helps to lift the lid on how each company in the market is being perceived by the analyst community.
In the next article in this series, we will explore whether it is possible to make money by following analyst recommendations. We will look at the evidence that these recommendations can be profitable (or otherwise), the factors that can adversely influence recommendations and the costs of such a strategy.
In this series:
1. Understanding analyst research, who writes it and what it tells you
2. Can you make money from analyst recommendations?
3. How to think differently and use analyst research to your advantage
4. Putting it all together – three strategies to make money from analyst research