Equity Analyst Reports
This article will be the first in a three-part series that examines equity research. The equity markets are hugely popular, yet they often remain something of a mystery to many investors. Equity analyst reports can help in this matter, but first, these need to be understood. In this article we will address the following topics:
- what is contained within an analyst report;
- how the recommendations of analysts are often in conflict;
- how analyst reports should be most appropriately utilized.
Understanding the report
It is common to receive equity analyst reports when you subscribe to brokerage services. These will usually be sell-side analyst reports, which tend to be the most widely distributed among the general public. Sell-side analyst reports usually comprise of the following sections:
- Basic company information and business description;
- 12-month target price usually based on:
- An average of the estimated prices derived from different valuation methods or;
- An adjusted price with a discount or premium, based on qualitative factors;
- Buy (Overweight) / hold (Neutral) / sell (Underweight) recommendations;
- Often recommendation are dispersed over 5 grades, which include Strong Buy, and Strong Sell;
- Key developments regarding the company and any related sectors;
- A wide variety of legal disclaimers.
It is common for investors to immediately focus on the target price and buy/sell recommendations when first viewing an analyst report. This tendency particularly arises when the report correlates with their beliefs about the stock market, creating unhealthy confirmation bias. This can then lead to the hasty execution of a trade, but the meat of the report is never really used in any meaningful way. The trader that engages in this conduct will then wonder why they have failed to succeed on the stock market, yet repeat the same behavior over and over again every time they receive an equity analyst report. But trading successfully based on merely the target price and recommendation is about as likely as finding a pot of gold at the end of every rainbow.
If we want to understand equity analyst reports, we must first understand the way that they are compiled. Firstly, these reports are unquestionably focused on institutional investors. The institutions often trade a lot more value than retail investors and they pay commissions on such trading activity. Brokerages make a profit from the volume of trades, regardless of whether these are successful for the client or not. It stands to reason that sell-side analysts will want to encourage clients to trade, and the less scrupulous among them will not be hugely concerned about whether or not these trades are good or bad.
With this in mind, sell-side analysts often encourage clients to trade companies that they are covering, especially those that they have assisted in the process of going public. This bias is often discussed in financial literature and does have a massive impact on the equity market.
Another issue is the focus on short-term results in order to encourage immediate action from clients. There is nothing inherently wrong with immediate action, but emphasizing this at the expense of more strategic approaches can lead to impulsive trades. Naturally, when dealing with something as complex as the equity market, this doesn’t necessarily lead to an optimal strategy.
Following the Herd
Equity analysts are judged by institutional clients on their predictive accuracy, and thus making bold predictions can reflect poorly on them. Following the herd can be beneficial for analysts, but it is not necessarily ideal for equity trades. This is an obvious conflict of interest and is another factor which tends to lead to the reports being focused on short-term returns. Research indicates that on average, target prices in equity analyst reports exceed the actual prices by 15%, with only 38% of the target prices actually met by the end of the forecast period. The consequences of this are obvious…it is highly unwise to rely on target prices and recommendations alone.
Dealing with Reports
Nonetheless, you shouldn’t automatically shred analyst reports, as they still contain some useful information. So here are three quick tips to help you get the best out of them.
Firstly, the key development section of the report is important, particularly when you are unacquainted with the industry or company. Always pay attention to factors that can impact the industry and company in the longer term, as such trends will have a significant impact on trading viability.
It is also valuable to particularly focus on key industry metrics, which will enable you to quickly understand how is the industry and company measuring success. One example is the Passenger Load Factors for the airline industry. It is also important to know that just because an industry is set to bloom, it doesn’t mean that all companies in the industry will perform well, so understanding which segment the company is in the industry is critical to investing.
Finally, research has shown that when multiple analysts downgrade a company, the recommendation has a higher probability of being correct. They will often only do this because they believe a drastic change has arrived at the company, such that they will risk being wrong about their recommendation, then not making any comments at all.
In summary, analyst reports can be highly useful, but they should be viewed as an indication of the market, rather than something which is set in stone.