There are mixed views on brokers' recommendations. What's an investor to do?
Q: How many Stockbrokers does it take to change a lightbulb?
A: "One, but he'll need to change it several times a year and charge commission each time".
Brokers' forecasts are often used to justify the price of a share going forward. "The broker is forecasting earnings per share of 5p next year, rising to 7p the year after, placing the shares on a forward price-to-earnings ratio of just six. Strong buy." etc. But just how useful are the forecasts?
Best ignored?
Many Fools will tell you that brokers are best ignored. And a look back in time reveals the awful truth! Alan Oscroft demonstrated just how inaccurate brokers are; often recommending the exact opposite of what we try to achieve as investors: "BLASH" (buy low and sell high).
I remember doing an analysis in 2001 of all the FTSE 100 constituent companies to see which enjoyed the highest overall average broker rating. And the answer? Energis. The former FTSE star that went into administration in July 2002 rewarding investors with zilch before becoming a subsidiary of Cable & Wireless (LSE: CW).
Why pay?
Companies pay for the services of a broker to act as the link to the City. In some cases the broker is also the AIM Nomad, which is an additional service that handles the relationship between the company and the London Stock Exchange. Issuing analyst notes is part of the service offered by a house broker. And the house broker's forecasts usually tend to be fairly cautious, as most companies want expectations to be prudent so they can beat forecasts on results day.
Consequently, the house broker's numbers are usually a little below average for a group of analysts. But where the house broker almost invariably pumps the company is in the headline "buy/hold" etc recommendation and the top paragraph or two on the front page of the note.
This calls for caution from investors of course. The brokers are positive on the company because they are paid to be, and because their relationship runs more smoothly if their public stance is enthusiastic. Nonetheless, many brokers and individual analysts do an excellent job, have well-deserved City reputations for providing intelligent insight and are well worth their fees.
A healthy dose of salt
To be safe overall, though, take it down one; so treat a "hold" recommendation as the equivalent of a "sell" etc. -- or simply ignore the buy/hold recommendation and first few paragraphs of a piece of research by a corporate broker. Read it, instead, as you would a piece of "promotional" financial information from the company itself. That certainly doesn't make it worthless. Such reports often offer useful insights, additional information and good forecasts -- you just need a dose of salt to go along with them.
Some brokers, though, have far dodgier reputations built on "bigging up" companies' prospects far beyond their means to deliver in reality. Such firms develop something of a "reputation", and the City pays less heed to them as a result. But it doesn't stop companies paying their fees as they enjoy having their egos massaged and the hyperbole that goes with it.
The moral…
So where does all this leave us? I would say a healthy cynicism is necessary. The longer term one's investing horizons are, the more of a contra-indicator do brokers' recommendations become.
The City thrives on the short-term approach. It is its lifeblood. It's what keeps traders coming back for more and helps keeps brokers' commissions rolling in.
But for the Foolish investor, the long-term approach is the right one. And on this basis, brokers' reports and forecasts should be used as a useful but relatively small piece in the overall investing jigsaw.
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