Does it pay to follow brokers' recommendations?
Six months ago I started a little experiment: I identified the shares that were most beloved of the brokers, and those that were decidedly in the doghouse, with the intention of seeing which group performed better.
Before I continue, which group do you think should outperform? Place your bets now please, ladies and gentlemen.
The theory
There are two theories about this: Firstly, some would argue that the professionals have studied the markets and the companies and therefore know what they are doing, and consequently their tips should be worth following.
Contrarians will argue, on the other hand, that as the market knows what the professionals think, it will have discounted this information in the price of the shares. Their buy tips, for example, will already be desired by the market, and the share price will reflect this.
If a share is strongly 'in favour', then more good news will not make a significant difference to its popularity and price, but any disappointment will be severely punished. Conversely, if a share is strongly out of favour, any bad news is expected and won't hurt is significantly, but it will rally on the first sign of good news. All that matters is surprise.
Well, those are the theories, and to the extent that I'd take any heed of broker recommendations, I subscribe to the latter school. I believe that markets over-react to good and bad news, that brokers tend to lag the market in their predictions, and that some brokers may have their judgement clouded by a desire to drum up business.
The practice
So what did the results reveal? Annoyingly for contrarians, and for me, the brokers' buy tips outperformed the market, while their sell tips underperformed.
Over the six-month period, the FTSE All-Share index rose by 14.7%, but the buy tips returned 24.7%, a full ten percentage points more.
Data source: Digital Look
The sell tips did well too, but did not quite keep pace with the market, gaining 12.8%.
| Company | No. of
brokers | Neutral | Sell | Strong
Sell | Return
(6 months) |
|---|
| Liberty International (LSE: LII) | 16 | 3 | 4 | 9 | -1.4% |
| Halma (LSE: HLMA) | 11 | 10 | 0 | 1 | 29.6% |
| Dimension Data (LSE: DDT) | 7 | 6 | 0 | 1 | 59.6% |
| French Connection (LSE: FCCN) | 5 | 2 | 0 | 3 | -42.4% |
| Innovation Group (LSE: TIG) | 5 | 4 | 0 | 1 | 21.4% |
| Romag (LSE: ROM) | 5 | 4 | 0 | 1 | 10.1% |
| Average | | | | | 12.8% |
| FTSE All-Share | | | | | 14.7% |
I'm ignoring dividends, but they would not change the overall picture. So it's one-for-one to the professionals. I'm not quite taking it all back, but still, credit where it's due.
Bear in mind also that this is just one snap-shot in time, and using the very small cohort of companies that were unequivocal buys and sells. This is not enough for me to decide to slavishly or mechanically follow brokers' recommendations.
The curiosity
It does intrigue me enough to run another filter on the current batch of brokers' recs and see what that tells us. Similar to the last time, it is much easier to find buys than sells -- it always is, and that is one my reasons for being suspicious of recommendations.
As a result the buy list is reasonably well populated with companies that are closely followed and have just 'buy' and 'strong buy' recs.
For the sells, I again have to include companies that have some 'neutral' opinions, and even then I only get five candidates that have three or more brokers following. And one of those, Numis (LSE: NUM), has purely neutrals, but many maintain that 'neutral' or 'hold' is code for 'sell'.
| Company | No. of
brokers | Neutral | Sell | Strong
sell |
|---|
| Liberty International (LSE: LII) | 17 | 8 | 4 | 5 |
| Luminar Group (LSE: LMR) | 9 | 3 | 1 | 5 |
| AEA Technology (LSE: AAT) | 3 | 3 | 0 | 0 |
| Liontrust Asset Managament (LSE: LIO) | 3 | 1 | 0 | 2 |
| Numis Corporation (LSE: NUM) | 3 | 3 | 0 | 0 |
Just out of curiosity, let's see how this lot performs.
More from Padraig O'Hannelly:
Note: No investors were harmed during the conduct of this experiment.
