How to use brokerage research reports

The Business section of yesterday’s New York Times had an interesting article in it, pointing out that during the current stock market downturn the typical Wall Street analyst recommendation has been “buy” not “sell.”   A similar study of any other downturn would likely produce the same results.  Why is this?

There are lots of pragmatic, institutional reasons why it’s so difficult for an analyst to write “sell” (more about this below).  Also, as investor sentiment indicators–which are invariably most bullish near the top and most bearish at the bottom–illustrate, it’s psychologically much harder than it might seem to either buy low or to sell high. Ff there may not be much information in the analyst recommendation, then, what are the really useful parts of an analyst’s research report?

1.  Analysts have lots of factual information about companies and the markets they are in, so a basic report, either for an industry or a specific company, can be a good way to get up to speed quickly about a stock.  Most Wall Street research is organized by industry.  Large or complex industries, like technology, health care or oil, will have several analysts covering it, each one specializing in an industry subsector.   Analysts may well have worked in the industry they are following.  They are in frequent contact with the managements of companies they cover, as well as with institutional portfolio managers and analysts who may be interested in these companies.  This latter group may well have its own in-house expertise and independent information gathering network.  None of these parties will be shy about giving the analyst their take on industry or company prospects, or on the accuracy and completeness of the analyst’s reports.  This constant give-and-take usually forces the analyst to get very good very quickly.  (Some firms have short versions of these reports that are meant for individual investors.  If you’re serious about studying a company or an industry, you want the reports for institutional investors.  For a basic report, it’s ok if it’s even a year or two old.  The facts are what you want.)

2.  Analysts can usually separate the stronger companies in their industry from the weaker. This is the positive flip side of the fact that their industry-specific focus makes it harder for them to compare the merits of their industry with the rest of the market.  To get a specific order from top to bottom, you may have to ask the analyst–who may or may not reply.  (Remember, too, there may be times when the weaker company is the better investment.)

3.  Reports will normally have detailed financial projections by business line. This will allow you to get a quick sense of the parts of a company that may be more profitable or faster-growing.  Typically, analysts don’t want to release their most complete spreadsheets, for fear their competitiors may “borrow” them, but you should get enough to go on.

4.  Analysts will project earnings per share. Compare these with company guidance and the consensus.

Why are analysts so bullish?

1.  Their industry is their livelihood. It seems to me that, over time, analysts increasingly identify themselves with the industries they cover.  (This certainly was the case when I was an analyst.)  They may speak at trade conferences, they appear on television or radio, they have lunch with powerful investment managers–all because of their specialized knowledge.  It becomes increasingly difficult for them to conclude that this knowledge is going to be irrelevent to investors for, say, the next two or three years.

2.  Not everyone likes to hear a “sell” call. In fact, if press accounts are to be believed, lots of powerful people don’t.  Even in the Regulation FD era, there are plenty of ways a company can signal its displeasure at an analyst downgrade.  The company may not return his telephone calls so quickly, or not attend a conference he’s organizing, or go to visit money managers with a rival instead of him.  There’s a (small, I think) risk that investment banking business may go to a competitor, as well.   In addition, big holders of the stock may complain to the firm he works for, or reduce the volume of commission business they do with his employer.  None of this petty behavior may be likely, but why take the chance?

3.  Analysts don’t cover every company. There is certainly more call today for “pair trades”–long company A, short companyB–than there was five or ten years ago.  But there’s little upside to covering a chronically weak company that will be a constant “sell.”  It’s easier not to follow it at all.

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