Economic Times, 10/1/11
Are you the kind who relies on research reports brought out by stock broking firms to invest money in the stock market? Well, think twice before you do that again. Things may not be as straightforward as they appear. To know the real story behind the entire business of broking houses bringing out research reports, read on.
These days most broking firms that serve retail or institutional investors have a research team. This research team mainly tracks stocks and identifies investment opportunities for investors. Analysts research companies by understanding their business, meeting the company management and running numbers to check if the current price of the stock is justified. This research is communicated to both existing and prospective investors of the broking firm in the form of a report.
These reports typically carry a recommendation at the start, like buy, hold or sell. If the report flags a buy, the recommendation to the investor is to buy the stock. In case of a sell, the recommendation is exactly the opposite ie, to sell the stock. A hold recommendation comes somewhere in between and is meant for those investors who already have the stock. The recommendation to them is to hold on to their current investment and not to buy more.
There are various reasons for a broking house to bring out research reports. "Whenever a stock brokerage feels a stock is undervalued and clients could benefit by buying that particular stock, the reasons for buying the stock are put together in a research report," says Alok Ranjan, portfolio manager, Way2Wealth.
A stock is supposed to be undervalued, when an analyst feels that the current business prospects of the stock are not reflected in the price of the stock. Given this, they recommend that the stock should be bought because they expect the price of the stock to go up in the days to come.
There are brokers who primarily serve institutional clients. These brokers typically tend to cover large-cap stocks. They bring out reports to update clients on the impact of recent developments, future concerns or business opportunities. Stocks like Reliance Industries, Larsen & Toubro, Infosys and TCS are covered regularly by large broking houses.
These, of course, are some of the reasons why research reports are brought out. We will come to other reasons a little later in this piece. Bringing out a good report with a compelling investment argument is a time-consuming process. "An analyst could take anywhere between a week to month for making a research report," says Sadanand Shetty, V-P & senior fund manager, Taurus Mutual Fund.
Moreover, setting up a research team is a costly process for any broker. The cost involves buying databases which have the numbers necessary to carry out research. Hiring senior research analysts can also cost a bomb. And after incurring all these costs, a research report is given out free.
"Brokerage reports are available free in India, so research is a cost centre," says a fund manager with a domestic fund house. So, why do stock broking firms spend so much money to bring out research reports and then give them away for free?
We have seen the genuine reasons why stock broking firms bring out research reports. But there are other reasons as well. As Andy Kessler writes in the book, ‘Wall Street Meat’, "Companies report earnings once a quarter. But stocks trade around 250 days a year.
Something has to make them move up or down the other 246 days. Analysts fill that role. They recommend stocks, change recommendations, change earnings estimates, pound the table – whatever it takes for a sales force to go out with a story so someone will trade with the firm and generate commissions."
Reports essentially are a medium which allows the sales force of the stock brokerage to go out in the market and sell stocks. And how does that help? For this, investors need to understand the business model of brokers, says a veteran stock broker on Dalal Street. "The prime objective of a research report is to induce a transaction," he adds.
Every transaction gives broking income to the broker, which is his bread and butter. "A report is a tool to sell stocks," says a branch manager at a brokerage house. In order to sell stocks to investors, it is very important for broking firms to keep coming up with buy recommendations on stocks. As Mitch Zacks points out in his book ‘Ahead of the Market’, "A buy recommendation has more value to a brokerage firm because it gets the brokers on the phone selling stocks to new clients and opening new accounts."
A buy report ensures that the broking house has a chance to make far more money than it ever would by putting out a sell report on a stock. This is because only those investors who have the stock will consider selling it, so the income will be limited to that extent. This, of course, does not hold for a buy report.
Also, at times, owners of stock broking firms own shares or the broking house owns shares for its portfolio management services’ (PMS) clients. If a particular stock does not do well, it is quite possible that a broking firm may release a ‘buy’ report on the stock. This may tempt investors to buy the stock, thus boosting the stock price. This will give the owner or the broking house an opportunity to sell out of the stock.
This, of course, does not mean that no research report can be trusted. Over a period of time, savvy investors learn to separate the wheat from the chaff. "The brokerage from where the report originates, tells me about the quality," says Alok Churiwala, a Mumbai-based broker.
While seasoned investors may be able to differentiate one report from another, retail investors have to trust their broker. So, what should a retail investor do? Some large brokerages these days carry disclosures on whether they own a particular stock, if they are recommending it. These reports also point out whether a sister firm of the stock brokerage has an investment banking relationship with the company. This is something that retail investors should look out for.
"For retail investors, the only way out is to check the past track record of the brokerage house and then decide whether to trust the reports or not," says Ranjan of Way2Wealth.
So, investors should thus be careful and do their own homework on the stock, rather than buy or sell because of an analyst recommendation. As Zacks says, "One of the biggest and most correctable mistakes you can make using analyst recommendations is to allow the recommendations as a means by which brokers can sell you a stock. You may not fully realise that the more you trade, the more money your brokerage firm makes."
1. There may be cases where many times a Buy report is issued in agreement with the management!
2. Same may be the case with Mutual Funds, where the ranking’s must always be taken with a pinch of salt.
3. We at VRIDHI strongly believe that Investor’s can only be Empowered by Educating them time to time.