How to intelligently use analyst research reports

When a broker or research firm issues a Buy, Hold or Sell recommendation, should I act immediately?

Should I believe whatever they say?

What does a target price mean?

How do I make sense of and use the research information to make informed investment decisions?

What do I do if I receive contradictory recommendations or information from different brokers?

There are so many research reports to read. I am suffering from information overload. What do I do?

These are some of the common questions raised about the usage of analyst recommendation and research report. We will examine each of these questions in turn. But first, for the benefit of those who are new to the financial markets, we will briefly explain the what, who and how about analyst research report.

What is an analyst research report?
An analyst research report gives investors:
(1) a quick overview of the company's recent developments,
(2) the analyst's view of the likely operational and financial impact,
(3) the resulting change in the analyst's earnings forecasts,
(4) the analyst's educated guess of the share price in 12 months' time,
(5) the catalysts likely to influence the share price within that time frame, and
(6) the analyst's recommendation for the stock.

This is a sample copy of an analyst research report:

Who produces them?
Traditionally, analyst research reports are produced by brokers. They are provided free to their clients as a value-adding service. The major brokerage houses are: ABN Amro Morgans, Citigroup, Credit Suisse, Deutsche Bank, JP Morgan, Macquarie Equities, Merrill Lynch, and UBS.

In recent decades, more independent research firms have emerged as an alternative producer of stock research and recommendation. This is because of the criticism that brokers are biased in their recommendations and do not actually look after the interests of users of the reports. We will discuss this particular issue in greater detail later.

How do I get them?
If you are a client of a brokerage firm that produces research reports, all you have to do is ask your broker for them. You could also obtain independent research reports on a paid annual subscription basis or by purchasing them individually as needed.

How do I use them?
Analyst reports are a great source of information on companies. As it is not possible for retail investors to research every company in detail due to time and skill constraints, analyst research reports are especially valuable in helping investors gain a quick insight into companies' operations, outlook and growth potential.

However, before you start to use a broker's research report, you need to understand their underlying biases.

BIAS 1: Brokerage firms are motivated to issue Buy or Sell recommendation, instead of a Hold. The reason is simple. Brokers only make money when you trade, not when you sit on the sideline.

BIAS 2: Brokerage firms are motivated to issue positive recommendations and hold back critical comments because of the fear that it may offend existing and potential clients of their investment banking division. Even though the investment research division (a cost centre) and the investment banking division (a profit generator) of brokerage houses are separately managed in order to avoid this conflict of interest, the reality is such a bias still exists at some brokerage firms.

BIAS 3: It is easier for analysts to find positive information than negative information about companies. Therefore, their research will reflect this bias. The reason is, CEOs and CFOs are often very helpful in supplying good news about their company but will seldom voluntarily disclose bad news unless and until they are legally obliged to.

BIAS 4: Analysts sometimes delay issuing a negative commentary or recommendation downgrade because of the pressure they receive from portfolio managers within the brokerage firm. The portfolio managers may hold large positions in a stock.

BIAS 5: Analysts who derive a valuation far from the market consensus or the share price are often victims of self-doubt. The likelihood is, some will adjust their numbers to make the final valuation figure closer to consensus. Such post-valuation tinkering diminishes the value of their independent opinion. Sometimes, the uncommon view turns out to be the right one.

In addition to the biases, broker's research reports are also subject to a range of shortcomings:

SHORTCOMING 1: Analysts rely primarily on fundamental analysis and focus on a long-term investment horizon in deriving their recommendation. Actual short-term share price movements are not a consideration. The share price may fall further after a Buy recommendation is made, and investors need to have a certain amount of trust and conviction to stick with the recommendation. This trust and conviction may sometimes work against them if the share price fails to later gravitate towards the analyst's target price.

SHORTCOMING 2: Although fundamental analysis, like technical analysis, is an ongoing process, a trade-off between timeliness and reliability of new information means that research recommendations may not be adjusted as frequently as investors would like. Some analysts prefer to wait until an event has occurred before changing their recommendation and forecasts. Others prefer to be pre-emptive and factor in possibilities.

SHORTCOMING 3: Because new information emerges on a daily basis, research reports are subjected to time decay in its value. Generally speaking, an older research report is less useful in terms of informational value than a more recent one.

Given these biases and shortcomings mentioned above, you would ask yourself, "so what good are these research reports!". The truth is, despite their imperfectness, research reports are still valuable because:

1. Stock recommendations and share price targets often turn out to be self-fulfilling prophecies. Fund managers do follow the recommendation of highly-paid analysts. One reason is so that if something goes wrong they could avoid taking responsibility and blame it on the analysts!

2. As mentioned earlier, it is impossible for most investors to do detailed analysis on different companies due to time and skill constraints. The analysts provide an invaluable service by reporting on share price-sensitive events and quantifying their impact on companies' future earnings.

Now that we have explored the pros and cons of brokers' research reports, we will answer the questions posed at the beginning of this article.

Should I believe everything they say?
No. You certainly should not follow stock recommendations blindly. When you receive a newly-published research report, you should read the analyst's rationale for making or changing his recommendation and forecasts. And decide for yourself if they make sense to you. Consult the stock chart and perform your own technical analysis. If you feel that the recommendation makes sense, you should act on it as soon as possible.

What does a target price mean?
A target price is what the analyst believes the stock should trade at in approximately 12 months' time. This target is derived from a valuation of the company's shares, taking into account matters such as potential for corporate activity, management capability and uncertainty as well as the valuation multiples of similar companies.

You should not think that the share price will definitely reach this target in 12 months' time. It is just a guestimate.

One of the common mistakes beginners make is to look for and buy stocks with the largest difference between the target price and current share price. You should avoid this pitfall.

How do I make sense of and use the research information?
Remember this basic formula: Profit = Revenue - Cost

A company's share price is primarily influenced by the company's profitability (expressed in Earnings Per Share).

From the research reports, you should try to identify the major revenue and cost drivers of different companies and where they are heading. They are the leading indicators of profitability and share price.

What do I do if I receive contradictory information?
Sometimes, you will receive contradictory recommendation from different analysts. This is a good thing. Stock recommendation in itself is meaningless if it is not supported by strong rationale. Examine the reasons put forward by the different analysts and come to your own conclusion.

How do I avoid information overload?
Make your own notes on companies. Jot down relevant points you receive from research reports. Over time, you will build up the expertise to quickly sieve through reports and extract key information from them.



Summary

1. Analyst research reports are a great source of information.

2. Understand the biases and the shortcomings.

3. Stock recommendations and target prices are not as important as the rationale supporting them.

4. Ensure your broker sends you new reports as soon as they become available. The older a report, the less informational value it carries.

5. Always check the share price chart to determine suitable entry and exit levels.

6. Use the research reports to build up your analytical ability and to become a better investor.



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