How to Profit From Brokerage Research

Though brokerage analysts are frequently wrong with their recommendations and price targets, there is value in their research. The key is to know what to look for and what to ignore. Here are three key items I discuss in my book, Better Good than Lucky: How Investors Create Fortune with the Risk-Reward Ratio.

The buy or sell rating is typically the most often quoted part of a research report. The inherent problem is that brokerage analysts are infatuated with the word “buy.” According to Zacks.com, approximately half of all stocks covered by analysts currently have the equivalent of a “buy” recommendation. Conversely, just 2.5% have the equivalent of a “sell” rating. (Obviously, if so many stocks are buy candidates, wouldn’t a more cost-efficient strategy for brokerage clients be to simply invest in an index fund, such as the S&P SPDR (SPY)? Such a strategy would certainly save on transaction costs, while still providing exposure to many of those “buy” candidates.)

The simple fact is that analysts loathe putting a sell rating on a stock. This is why you should look past the rating and instead pay attention to what factors the analyst is looking at. Specifically, focus on industry statistics, specific ratios and other criteria that shed light on how the business is doing. For example, if the analyst cites a specific industry report or publication, see if it is available on the Internet. Such data will give you a good framework for doing your own analysis of business trends.

Analysts’ price targets also receive a lot of attention. The problem is that a price target is nothing more than an educated guess. Most frequently, analysts rely on discounted cash flow (DCF), a mathematical model that calculates how much a company’s total future cash flows are worth today. Like any model, DCF is only as good as its inputs and the inputs are based on many assumptions. To give you an idea of just how difficult it is to forecast cash flow, consider your own personal situation. You might have a decent idea of what your salary will be two years from now, but can you tell me how much cash will you have after spending on home repairs, car repairs, medical bills, vacations, taxes, etc.? Forecasting cash flow for a company is even harder.

Since a company is ultimately worth what it will earn in the future, DCF does have a place in valuing a company. However, since DCF is based on assumptions, a margin of error needs to be applied to the number calculated by the model. I suggest investors assume any price target based on DCF is at least 10% too high in order to provide some room for error.

Finally, there is the projection of what a company will earn in the future. Though everyone likes a positive earnings surprise, the fact that Thomson Reuters says 73% of S&P 500 companies topped third-quarter consensus estimates shows just how wrong analysts are. This said, as a group, analysts do tend to be fairly good about judging whether profits will be better or worse than originally thought. Thus, a change in the consensus earnings estimate can provide some insight. Specifically, rising estimates are a good sign and falling estimates are a bad sign. Be sure to take note of the magnitude of the change as well. A one-cent change in projected profits of $1.00 per share is not very significant; a one-cent change in projected profits of a nickel per share is.

Most importantly, treat brokerage research as just one part of your analysis, not the sole reason to buy or sell a stock. Research reports are written for mass audiences and the arguments stated in a report may or may not apply to your investing style or personal criteria.

Charles Rotblut, CFA, is a Vice President for the American Association of Individual Investors and the AAII Journal Editor. His new book is Better Good than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio