Sharebroking and investments: The analysts strike back on sell recommendations

Friday 22nd March 2002

The critics fail to understand the markets' reality, argues ROB MERCER

Why do so many people get frustrated that analysts don't have more sell recommendations?

Cynics say the motive for their relative scarcity is that analysts are trying to protect their corporate relationships - that they are not independent enough within their own firms. I doubt you will find too many analysts proud of having relationships with companies that show serious share price declines.

There seems also to be an implicit assumption that there should be an equal number of buy and sell recommendations. But share price movements are not a zero sum game.

Last year nine companies in the NZSE40 index went down: Air New Zealand, Fletcher Forests, Waste Management, BIL International, Telecom, Baycorp, Telstra, Foreign and Colonial Investment Trust, and Natural Gas. They represent 22% of the 40 stocks by number but 33% of the index by capitalisation. The majority of these companies' share prices fell due to unforeseen events rather than overvaluation issues.

If sell recommendations are based simply on the view that the share price is going to fall then you are always likely to get a greater proportion of buy recommendations because history shows us that, in the long-run, sharemarket returns are positive. It is therefore similar to fighting gravity thinking a share price will trend down in the long run.

The frustrating reality is the events that tend to drive share prices down are often very difficult to predict, and making a recommendation based on some future negative shock hardly seems credible. When it comes to bad news, it normally catches everyone by surprise.

Members of the New Zealand Society of Investment Analysts (NZSIA) are challenged daily by the responsibility for forming and communicating recommendations to a diverse group of investors. It is too simplistic to place a high weighting on any single recommendation framework such as buy:hold:sell, or overweight:marketweight:underweight.

While a simple and definitive buy/sell recommendation would be nice, the fact is markets are highly complicated and contain many different investor types making a simple one-word summary of advice difficult. More often than not, the direction of the recommendation change is as important as the recommendation itself. Looking at the recommendation without knowing the history can be dangerous. The best informed investors will therefore have a close relationship with a qualified broker who can help put the recommendation into context, particularly when it comes to his or her overall portfolio.

Here are two examples that demonstrate the confusion surrounding sell and underweight recommendations.

Example 1: The other day I was asked if a stock should be bought for a client's portfolio. My reply was "no" because I preferred several other companies. The adviser's response was, "why is your recommendation a hold and not a sell, then?" to which I replied, "what difference would that make?" If I do not think it should be bought, logic might seem to suggest I would recommend someone who already owns it should sell it but there may well be reasons that that particular stock may continue to warrant a place in the portfolio.

Example 2. An institutional portfolio manager has 15% of their funds in Telecom versus a benchmark weighting of 20%. In other words the manager is 5% underweight the benchmark weighting in Telecom, which in a simple buy/sell framework would suggest the manager believes Telecom is a sell. The same manager may believe the best performing company over the next year will be Pacific Retail Group but take only a 5% weighting in the portfolio due to the relatively small size of the company.

Hang on - Telecom is a sell and the manager owns 15% in the portfolio and Pacific Retail Group is a buy and he or she only owns 5%. Why would you have three times as much of a stock that's a sell? Clearly the implementation of recommendations in portfolio management is not based on simple buy/sells.

Most analysts would only consider a sell recommendation if they had serious financial concerns about the company. Simply putting a sell on a stock because it has traded above an analyst's valuation is not typically seen as a robust enough basis. Quite rightly good companies such as Port of Tauranga, Baycorp Advantage, or The Warehouse tend to trade consistently at a premium to their valuations.

Another reason for the relative scarcity of sell recommendations is that many of the underperforming smaller companies are not researched. A large set of stocks, therefore, that could attract a higher proportion of sell recommendations are missed from the recommendation lists.

From an investor's perspective, the recommendation itself is probably less important than the detail presented in the research report. From time to time an investor will see two broking firms taking different views on the same stock. Equally, an astute investor may read a report and form quite a different conclusion to the analyst. This is perfectly acceptable and illustrates that the information contained in the written report may be interpreted differently and should be seen as more important than the recommendation itself.

Sharebrokers have attempted to improve the effectiveness and appropriateness of recommendations through "model" portfolios.

These can more efficiently convey how analyst recommendations should be used for various investor preferences. For example a growth-orientated investor is unlikely to want to invest in a value stock that the broker is recommending as a buy.

The bottom line is that investment advice based solely on a simple recommendation is foolish and the NZSIA places a greater emphasis on the quality of the analysis in research reports rather than the absolute recommendation.

Rob Mercer is the chairman of The NZ Society of Investment Analysts

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