Questions to Ask about a Stock Broker’s Investment Recommendations
An analyst’s recommendation about stock investments is certainly a better tip than what you’d get from your barber, but you want to view recommendations from analysts with a healthy dose of reality. Analysts have biases because their employment depends on the companies that are being presented. What investors need to listen to is the reasoning behind the recommendation.
Keep in mind that analysts’ recommendations can play a useful role in your personal stock investing research. If you find a great stock and then you hear analysts give glowing reports on the same stock, you’re on the right track! Here are some questions and points to keep in mind:
How does the analyst arrive at a rating? The analyst’s approach to evaluating a stock can help you round out your research as you consult other sources such as newsletters and independent advisory services.
What analytical approach is the analyst using? Some analysts use fundamental analysis — looking at the company’s financial condition and factors related to its success, such as its standing within the industry and the overall market. Others use technical analysis — looking at the company’s stock price history and judging past stock price movements to derive some insight regarding the stock’s future price movement. Many analysts use a combination.
What is the analyst’s track record? Has the analyst had a consistently good record through both bull and bear markets? Major financial publications, such as Barron’s and Hulbert Financial Digest, and websites, such as MarketWatch, regularly track recommendations from well-known analysts and stock pickers.
How does the analyst treat important aspects of the company’s performance, such as sales and earnings? The essence of a healthy company is growing sales and earnings coupled with strong assets and low debt.
Is the industry that the company’s in doing well? Do the analysts give you insight on this important information? A strong company in a weak industry can’t stay strong for long.
What research sources does the analyst cite? Does the analyst quote the federal government or industry trade groups to support her thesis? These sources are important because they help give a more complete picture regarding the company’s prospects for success.
Imagine that you decide on the stock of a strong company. What if the federal government (through agencies like the SEC) is penalizing the company for fraudulent activity? Or what if the company’s industry is shrinking or has ceased to grow (making it tougher for the company to continue growing)? The astute investor looks at a variety of sources before buying stock.
Is the analyst rational when citing a target price for a stock? When he says, We think the stock will hit $100 per share within 12 months, is he presenting a rational model, such as basing the share price on a projected price/earnings ratio?
The analyst must be able to provide a logical scenario explaining why the stock has a good chance of achieving the cited target price within the time frame mentioned. You may not necessarily agree with the analyst’s conclusion, but the explanation can help you decide whether the stock choice is well thought out.
Does the company that’s being recommended have any ties to the analyst or the analyst’s firm? During 2000–2002, the financial industry got bad publicity because many analysts gave positive recommendations on stocks of companies that were doing business with the very firms that employed those analysts. Ask your broker to disclose any conflict of interest.
What school of economic thought does the analyst adhere to? This may sound like an odd question, and it may not be readily answered, but it’s a good thing to know. Those who embrace the Austrian school of economics have a much better grasp of real-world economics (which means better stock investment choices) than those who embrace the Keynesian school.
The bottom line with brokerage recommendations is that you shouldn’t use them to buy or sell a stock. Instead, use them to confirm your own research.