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Anup Menon
Anand Ram

ASK an equity analyst whether or not a particular stock is worth buying and an affirmative answer is most likely. Or so it would seem if a cross-section of recommendations put out by analysts is anything to go by. A look at the recommendation patterns of analyst opinions from different equity houses across the country reveals that 8 out of every 10 recommendations is a `buy'.

The bias towards a `buy' recommendation is uniform across most industry segments. Investors may increasingly be steered towards `buy' candidates. Few, if any, recommendations focus on companies that investors should exit from. But the important question is whether investors profit from such advice. Given that analysts are better informed, should the small investor take such recommendations at face value and make them the basis for their stock-selection/rejection? But analysts can go wrong. And there is evidence of it.

Of a sample of stocks that Business Line surveyed, 83 per cent had `buy' recommendations. Only 8 per cent carried a `sell' while on the remaining 9 per cent, analysts debated between recommending a buy or a sell.

Precision of prescience

An analysis reveals that, most of the time, analysts' recommendations have paid off. In 53 per cent of the buy recommendations, analysts have been proved right. By this, we mean that the stocks moved up after they were so rated. Stock prices either moved down or were passive only 47 per cent of the time.

However, it comes as a surprise that analysts were more vindicated in their `sell' ratings, with 60 per cent of the stocks so rated bearing out the analyst's recommendations. Only in four cases out of ten did stocks see an uptrend in prices after getting a `sell' rating.

In the stocks where analysts differed in their judgement on whether to rate them a buy or a sell, only 15 per cent actually rose.

On the other hand, 46 per cent of the recommendations tilted in favour of a `sell'. The remaining 38 per cent of the stocks saw prices remain passive, neither justifying a buy nor a sell judgement.

To recapitulate, though sell recommendations were fewer, they were more accurate than the buy suggestions.

Recommendations are targeted, by and large, at institutional investors to whom they are circulated. It follows, then, that the true measure of an analyst's worth lies in the fact that his recommendation is accepted and followed. To judge if this was indeed the case, a random sample of well-traded stocks was taken and the institutional shareholding pattern ascertained to see if the scrips had risen or fallen (depending on whether they had a buy or a sell on them) during the quarter in which the recommendation had been made, and the one immediately after. The results were mixed, though in most stocks there is evidence that analysts' counsels are indeed put into practice.

In the samples of stocks with sell recommendations, the shareholdings of institutional investors had, indeed, decreased between 0.12 per cent and 3.83 per cent. `Buy' stocks, too, displayed a tendency to have institutional investors consolidate their holdings in them. In all the `buy' cases except one, institutions increased their holdings between 0.02 per cent and 4.88 per cent. Stocks that did not display a consensus of either buy or a sell prompted institutions to resort to either course of action. In the sample, institutions reduced their holdings in two stocks while they increased their presence in another. However, the magnitude of the change remained insignificant.

While there is an overwhelming patronisation of buys, it would be interesting to see if there is historical evidence to support the same.

Understanding recommendations

Stock recommendations are based on several parameters. Analysts get to understand a company as intimately as they can and study its fundamentals, management, financials and how it is valued in the market. Recommendations extrapolate these indicators based on what the analyst perceives the future to be and the course of growth of the company. This is where the skill of the analyst figures.

Revenue and profit estimates quantify the analyst's perceptions and form the cornerstone of stock recommendations. Invariably, most analysts measure the growth rate in sales, operating profits and other variables on a compounded basis. These growth rates are then used to estimate the market price of the stock in the future. Comparison of this with current market valuations is made to arrive at a `buy', `sell' or `hold' recommendation. Sometimes tools of technical analysis are also used to predict future price formations.

Analyst reports typically contain a target price. This is the signal for the investor that, if and when the stock hits the target price, he can proceed with the recommendation given by the analyst. Target prices, in other words, are levels at which the assessor feels the market fully impounds the fundamentals of the stock.

The whys of prophesising

Corporate houses that engage in equity work — stockbroking activities, managing portfolios, managing equity issues for corporate clients, etc. — have ancillary interests in undertaking analysis of companies and putting out their work for general consumption.

Conventionally, research reports are privileged and made available only to select audiences, such as institutional investors. However, the recommendation itself is more widely circulated. It makes good sense for brokerage houses to circulate a recommendation because, if the opinion is vindicated, investors repose faith in that company, driving brokerage commissions their way.

You are more likely to go to a broker whose opinions have made money for you. As a result, though research reports do not make their way directly to retail investors, their presence is felt in the recommendations made by these brokers.

The question, then, is whether these reports reflect a clinical evaluation of the company. In other words, are there influences that tilt recommendations in favour of the company? Globally, yes and locally too, perhaps. As merchant banking and equity broking call for a concerted sales pitch to the same audience, they have traditionally shared operations and identities.

As public issues have to be encouraged to be subscribed to, it may not be unusual to rope in an analyst from the broking team to prepare a report on the client company as well.

The conflict of interest happens when the analyst finds that the client's shares are not worth holding on to, whereas the other arm may lose business if shares are not sold. This puts the analyst in a spot and he is compelled to put out a favourable recommendation — much to the detriment of retail investors.

It is not unreasonable to assume that Indian analysts too may be subject to such conflicting forces. Besides managing public issues, investment or merchant bankers may be called upon to manage other equity work, such as public offers, offers for sale, acquisition of shares, buyback offers, and so on, for corporate clients. This brings in the delicate issue of trying to deliver an accurate verdict in the face of certain compulsions. A `buy' could, therefore, be the easiest way to avoid rocking the boat.

This is not to say that there are no `sells'. If the company in question has markedly limp fundamentals, analysts would do well to put out a `sell' to maintain their professional credibility.

Where growth rates and other factors that hinge on industrial and economic exigencies play a significant role in the recommendation, there is a case for rating houses to push these as a `buy'.

In any case, analysts are better off not taking the maverick route to rating stocks but sticking to acceptable forecasts that conform to the majority view. For, if their call were to go wrong, they could still find safety in the strength of numbers.

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