Judging Your Broker's Recommendations - dummies

Judging Your Broker’s Recommendations

In recent years, Americans have become enamored with a new sport: the rating of stocks by brokers on the TV financial shows. Frequently these shows feature a dapper market strategist talking up a particular stock. Some stocks have been known to jump significantly right after an influential analyst issues a buy recommendation. Analysts’ speculation and opinions make for great fun, and many people take their views very seriously. However, most investors should be wary when analysts, especially the glib ones on TV, make a recommendation. It’s often just showbiz.

Brokers issue their recommendations (advice) as a general idea of how much regard they have for a particular stock. The following list presents the basic recommendations (or ratings) and what they mean to you:

  • Strong buy and buy: Hot diggity dog! This is the one to get. The analyst loves this pick, and you would be very wise to get a bunch of shares. The thing to keep in mind, however, is that buy recommendations are about as common as snow in Alaska.
  • Accumulate and market perform: An analyst who issues these types of recommendations is positive, yet unexcited, about the pick. This is akin to asking a friend if he likes your new suit and getting the one-word response “nice” in a monotone voice. It’s a polite reply, but you wish the opinion had been more enthusiastic.
  • Hold or neutral: Analysts use this language when their back is to the wall but they still won’t say, “Sell that loser!” This is like when your mother told you to be nice and either say something positive or keep your mouth shut. In this case, this is the analyst’s way of keeping his mouth shut.
  • Sell: Many analysts should have issued this recommendation during 2000 and 2001, but few actually uttered it. What a shame. So many investors lost money because some analysts were either too nice or just afraid to be honest and sound the alarm and urge people to sell.
  • Avoid like the plague: Too bad this recommendation isn’t really available. Throughout history, plenty of stocks have been purely dreadful investments — stocks of companies that made no money and were in terrible financial condition that should never have been considered at all. Yet investors gobbled up billions of dollars’ worth of stocks that eventually became worthless.

Don’t misinterpret this. An analyst’s recommendation is certainly a better tip than what you’d get from your barber or your sister-in-law’s neighbor, but you should view them with a healthy dose of reality. Analysts have biases because their employment depends on the very companies that are being presented. What investors should listen to when a broker talks up a stock is the reasoning behind the recommendation. In other words, why is the broker making this 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 points to remember:

  • 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 type of approach does this analyst use? Some 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). Other analysts 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 may use a combination of the two. Is this analyst’s approach similar to your approach or to those of sources that you respect or admire?
  • 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 Web sites, such as MarketWatch.com, 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? How about the company’s balance sheet? Industry? The essence of a healthy company is growing sales and earnings coupled with strong assets and low debt.
  • Is the industry that the company is 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 to give a more complete picture regarding the company’s prospects for success. Imagine that you decide on the stock of a strong company. But what if the federal government (through agencies such as 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.
  • If the analyst cites a target price for the stock (“We think the stock will hit $100 per share within 12 months”), does she present 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 about 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 should help you decide whether the stock choice was well thought out.
  • Does the company that is being recommended have any ties to the analyst or the analyst’s firm? During 2000 and 2001, 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. This was probably the biggest reason that analysts were so wrong in their recommendations. Ask your broker to disclose any conflict of interest.

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. If you buy a stock based on your own research and later discover the same stock being talked up on the financial shows, consider the coincidence just be the icing on the cake. The experts may be great to listen to, and their recommendations can augment your own opinions; however, they’re no substitute for your own careful research.