Brokers' Recommendations Are Useless

Publishing share recommendations is big business for brokers, and if they're based on careful and knowledgeable analysis we might hope they'd be of some use. We'd be mistaken.

Why do we invest in shares? Obviously, because we think their prices are going to rise. And over the long term we're usually right (even if the past year has been a bit of a short-term disaster). Equally obviously, at any one time, 50% of the people with an actual interest in an individual share will be buying it and 50% will be selling it -- that's just how the price mechanism works.

What do the brokers say?

So what would we expect to find if we examined brokers' recommendations for a number of companies? Well, if they were any good at it, I'd tend to expect a general leaning towards Buy recommendations (because in the long term, stock markets rise), but on average not too far above a 50/50 long term balance between Buy and Sell tips. And I'd expect a preponderance of Buy recommendations in a bull market, and Sell recommendations in a bear market. But what do we find if we actually take a look?

I asked myself that very question back in 2001, when the FTSE-100 was coming down from the tech stock boom. I looked at a few large companies, and checked the number of Buy and Sell tips. And so I thought I'd repeat the exercise today, with the same companies.

Finding out what the recommendations said was tricky in itself, because brokers all seem to have their own language that obscures what they actually mean. So I collated all the recommendations that were clearly 'thumbs up' or 'thumbs down' tips, and ignored the rest. This time I left out a couple of banks that I'd looked at in 2001, because they are very different companies now from what they were then, and a direct comparison wouldn't make much sense.

Show us the tips

And here's what I found. The 2001 figures are from 3 July that year, with the 2009 figures coming from close of play last Friday, 27 March.

There's a couple of interesting turnarounds there. Seeing BT go from a unanimous Buy at 364p to a strong majority Sell at 77p opened my eyes a bit. BT has changed since 2001, though, having demerged its mobile businesses, and hasn't kept up with the competition in broadband.

It's also interesting to see the M&S turnaround, from a near unanimous Sell back in 2001 to a clear majority Buy today (perhaps ironically, at approx the same price in each case).

But those are digressions, because what is really interesting to me is to see the proportions of Buy and Sell tips. In July 2001, with the FTSE-100 at around 5,500 and with (as we now know with hindsight) still some way to go before the tech stock fall hit rock bottom, there were more than 3 Buy tips for every Sell tip.

And today, with the FTSE-100 way down around 3,800, we see the ratio a bit lower, with around 2.5 Buy tips for every Sell.

So it looks to me as if, no matter what the level of the market or its direction, the number of Buy tips significantly outweighs the number of Sell tips. And that really makes broker recommendations a pretty useless indicator of where share prices are likely to go next.

Why the imbalance?

Why are brokers' tips so heavily biased towards Buy recommendations? I think there's one very good reason. Remember, tips are designed to sell things -- analysts' reports, tipsheets, advertising space, or whatever -- and the more people they can sell to the better.

So who is the target audience for a Sell tip? It's really only those who already own the stock, and those who might be interested in shorting it. And for a Buy tip? Well, that's everyone. It's easy to see which kind of tip has the potential to attract the most punters.

If you're thinking of investing based on brokers' recommendations, I reckon you'd do better using tarot cards or goat entrails -- at least with those you'd get an unbiased random answer.