Analysing the analysts

Few people exert more influence over stock markets than analysts. Their reports are pored over by investors and are now more accessible than ever before, shaping how companies are valued and perceived on a daily basis.

Many retail investors struggle to understand the jargon littered throughout financial statements. Often, they may have limited knowledge of a company’s key issues, drivers, industry dynamics and competitive pressures and, sadly, cannot pick up the phone to get the lowdown from an inside source.

Analysts help to fill in those gaps and forecast what lies ahead, giving them the power to drive sentiment and move share prices even on quiet days when there are no corporate announcements. This continues to occur today, despite hordes of insider accounts and research dating back decades cautioning that whatever these trusted figures say should be taken with a pinch of salt.

Poor track record

Last year, the 10 FTSE 100 stocks most endorsed by analysts lost an average of 17.3 per cent, underperforming the index by 4.8 percentage points, according to data compiled by AJ Bell. Incidentally, the favourite, British American Tobacco, fared the worst, while the only pick from the list that came good, biopharmaceutical group Shire, did so because it got taken over.

Most popular ‘buy’ ratings – January 2018

Source: AJ Bell, Webfg, Broker Forecasts, Refinitiv

In fairness, one year is a short timeframe to measure success and 2018 was a particularly gruelling year for UK equities. This wasn’t a one-off, though. The big companies championed most by analysts have now underperformed the rest of the market every year since AJ Bell first started running its study in 2015.

With a track record like that, it’s fair to assume that these so-called experts, collectively, aren’t very adept at predicting the future, at least based on their buy recommendations.

Sloppy habits

Over the years, former colleagues, economists and other financial experts have accused analysts of many things. Armed with years of research, and in some cases insider experience, they concluded that individuals in this profession:

• Are scared to make bold calls – it’s better to be wrong like everyone else than be the only one who exercised poor judgment. Reputation is everything and contrarian tips can end careers, so they follow the herd to play it safe.
• Copy each other – when struggling for time or information they sometimes replicate what peers have written.
• Are guilty of neglect – analysts are often too busy to keep regular tabs on every stock on their list and don’t need to worry about cutting losses or locking in gains as it’s not their money on the line.
• Are stubborn – admitting defeat is embarrassing, so they stubbornly reiterate previous calls and fall victim to confirmation bias, shunning any evidence that runs counter to their original theory.

Mifid II, the revamped version of the EU-wide Markets in Financial Instruments Directive introduced in January 2018, ordered brokers to charge investors separately for research, rather than bundling the cost into trading commissions. Prohibiting the circulation of free notes was designed to boost transparency and the quality of stock analysis.

Unfortunately, it doesn’t appear to have panned out that way. Asset managers and other clients reportedly aren’t willing to pay out of their own pockets for the material being dished out by brokers. Mifid II has led to significant job losses in the industry and as a result, according to Steven Fine, chief executive of Peel Hunt, forced those analysts still in work to take on double the recommended remit of 15 companies.

Earlier this year, Gary Davies, chief executive of the Investor Relations Society, warned that the quality of research is deteriorating post Mifid II. Some members, he said, complain that seasoned professionals are being replaced with inexperienced juniors, and that it’s now commonplace for analysts to copy and paste from financial statements.

Other unintended consequences of Mifid II reportedly include biased house brokers becoming the only voice for scarcely followed small-caps, and smaller brokerages, many of which tend to do a better job of providing insightful, independent research, are being forced out of business, or into the arms of bigger rivals.

Conflicts of interest

The brokerage industry has been exposed as a deeply compromised affair on several occasions, the most famous example perhaps being during the dotcom bubble. Two decades after so-called star analysts were named and shamed for endorsing dodgy internet stocks they told confidants were rubbish, regulators are still struggling to rid the industry of its dark underbelly.

Decades of research shows that analysts frequently overhype the companies they cover, routinely opting for buy recommendations over sell tips, even when recessions and disasters are on the cards. Why? Because their careers often depend on it.

Table: FTSE stocks with the highest percentage of ‘buy’ ratings from analysts at the start of 2019

Source: AJ Bell, Webfg, Broker Forecasts

Some analysts continued to sing Carillion’s praises in the months leading up to its collapse. Prior to the calamitous July 2017 profit warning, 17 per cent of brokers covering the stock advocated buying it, while just a quarter ranked the shares a sell. The rest sat on the fence, even though the construction group’s gross mismanagement was by and large already in the public domain.

JPMorgan Cazenove slapped an 'overweight' rating on the stock in April 2017, with a price target of 292p. Nearly three months later, in mid-July, the investment bank downgraded Carillion to 'neutral', admitting it hadn’t adequately appreciated the sharp increase in receivables during 2016, the high level of outstanding payments owed to the group compared with its peers and the fact that the outsourcer’s debt facilities may not be sufficient.

Examples like this are common. Check out broker ratings on any one of the companies that look poised to join Carillion on the scrap heap, and you’re likely to find at least one analyst is still bullish.

Many others will eventually downgrade to a hold, rather than a sell, even though the annual reports they are supposed to read have been littered with major warning signs for years. These distress signals will almost certainly obliterate the shares once they are properly flagged by those who dedicate enough time to spot them, suggesting that analysts either aren’t doing their job properly or are purposely turning a blind eye.

Why would they do this? Read the disclosures in research notes; the small print section at the end. You’ll be surprised just how many potentially worrying admissions are made. Not everything will be mentioned, though, including the following: a breakdown of the main conflicts of interest that regularly influence which calls analysts make.

Preferential access

When an analyst has a good relationship with company insiders, he or she has a better chance of getting first dibs on the latest goings on.

A few years back Meredith Adler, a retired retail analyst at Barclays, told the Wall Street Journal that sell ratings sometimes resulted in analysts being starved of information and completely cut off, impacting their ability to do their job properly. Alarmingly, this revelation was made after lawmakers prohibited companies from showing prejudice and selectively disclosing private information to brokers.

Clients value private meetings with companies

Analysts might also want to cosy up to companies to bag private meetings with them for clients. Large investors, such as hedge and mutual funds, value highly the opportunity to hold exclusive Q&A sessions with upper management. That means whichever broker can offer this service is likely to get a lot more trading business coming their way.

Lining up private meetings for investor clients is a vital revenue source. It doesn’t take a genius to figure out that anything other than a buy rating will make these highly sought-after sit downs harder to facilitate. Again, former analysts have gone on record to confirm that this is true.

Representing the same company being analysed

The majority of brokerages are owned by firms with big investment bank franchises. Helping companies to raise money is a very lucrative activity, so much so that it often takes precedence over all other areas of business, including the distribution of independent stock research reports on equities.

Many brokers are responsible for objectively analysing the same companies that their employer is either representing or desperately trying to do business with. Edward Chancellor, in the book Capital Returns, gives his verdict on who the winner is, describing analysts as the “in-house propagandists” of investment banks.

Has Mifid II done anything to prevent this?

Mifid II may have unintentionally made this problem even worse. Last year, financial technology company ITG revealed that commissions paid to brokers to trade stocks fell 28 per cent in the UK during the first three months of the new regime.

Pundits familiar with the inner workings of these firms warn that this shortfall is likely to put more pressure on brokerages to chase work advising companies on raising finance, mergers and acquisitions and any other services they might require.

If true, analysts will be even more at the mercy of companies than before, clamouring to keep potential and existing clients sweet by writing nice things about them. Tying broker notes to even bigger corporate retainers, paid for by investors in the form of lower corporate profits, would effectively make them worthless.

How to use broker notes to your advantage

So why bother at all? Clear conflicts of interest mean all research should be treated with scepticism, bar the odd exception. Some analysts regularly do a great job and certainly don’t deserve to be put into the same category as their compromised peers. These individuals can offer value, which is why it’s always worth double-checking track records.

What about the rest? Surprisingly, even sloppy analysts occasionally have something to offer if you approach their research in the right way. The reliability of the buy/sell/hold headline is open to debate, although everything else below the main body of text should not necessarily be completely disregarded.

Read the fine print and scan the internet to see what conflicts of interest analysts might have. If in doubt, the general rule of thumb is to extract any fresh nuggets of information provided, cross-reference it and then make your own judgements.

Compromised or not, analysts do have access to high-level executives, meaning that they can reveal important titbits not available elsewhere, sometimes in plain English. Leveraging their years of experience covering stocks in complicated sectors could help you to make better informed investment decisions, provided that you also do your own homework.