You don't have to be an expert in finance and economics to invest in the stock market, because you can use the knowledge of others. Such invaluable information about specific companies is provided by the recommendations of brokerage houses (analytical reports), in which the situation in the company is sometimes broken down into its first parts: from results and margins, through the competitive environment, to industry scenarios and risk factors. A typical recommendation also includes the target price of the stock and a justification why the analyst expects it to increase or decrease.
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The advantages of such recommendations are specific. We get it “ready draft” of the investment thesis along with arguments and data and the sensitivity of the valuation to key assumptions. Reports too they organize information and facilitate comparisons within the sector. They can also be a good tool for capturing catalysts (product launches, regulatory changes, industry cycles) and for understanding what expectations the market already “has in price”.
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At the same time, you must remember that a recommendation is always a recommendation an opinion based on assumptions that may become outdated faster than the investor can click “buy”. They are often asymmetrical – historically “buy” recommendations are more common than “sell” recommendationsbecause institutions and analysts operate in relationships with issuers and the market.
Regulators explicitly warn against treating recommendations as the sole basis for decisions. Moreover, it is worth bearing in mind that the target price usually applies to a specific horizon (often 12 months).
Analyst Recommendations – How effective is it?
The big question is: do recommendations work? Research shows that the market reacts to new recommendations quickly, but not always fully. In a classic analysis of the recommendations of large brokerage houses in the USA, it was noted that after publication, the so-called “drift” (further price movement after the initial reaction): for a buy recommendation, it is on average small and short-lived (approx. +2.4%), and for a sell recommendation – more pronounced (approx. -9.1%) and extending up to half a year. This is an important indication that a “negative” signal can be informationally stronger because sell recommendations are less common, and when they do appear, the market reinforces this move more often.
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There are studies from Wall Street showing that strategies based on buying the highest rated and selling the lowest rated companies could generate approximately 4%. annual “surpluses” in gross terms, but they required very frequent responses. After taking into account transaction costs, the net results were not satisfactory.
We can therefore summarize that “monetization” of recommendations is difficult, because the strongest effect often happens quickly, and chasing changes in recommendations may generate commissions and spreads.
Analysts' recommendations in practice. How can an individual investor use them?
It is worth using analysts' recommendations as well-documented supporting material, not as a ready-made recipe. Market regulators emphasize that terms such as “buy/hold/sell” are not uniform between companies and an investor should read rating definitions, check the distribution of ratings in a given brokerage house and take into account disclosures about potential conflicts of interest.
The most effective method is to treat recommendations as tools to build your own thesis and control it. It's worth answering a few questions:
- what is the valuation horizon and what are the key assumptions (margin, growth rate, exchange rate, CAPEX)
- what would have to happen for the analyst's thesis to fall apart
- whether the target price results from one scenario or several
- how much of the valuation depends on parameters that cannot be easily predicted
- does the report talk about the company's competitive advantage and its sustainability, or only about a short “catalyst”
In the everyday practice of an individual investor, recommendations work best in three roles. First, as filter for building a “watchlist”: not to buy everything that has a “buy” rating, but to spot interesting companies.
Secondly, as narrative comparison tool: put together two or three recommendations from different institutions and check where they differ in their assumptions – these differences often say more than the target price itself.
Third, as “checklist” for risk management.
It is most sensible to use recommendations as good research: to understand the company, scenarios and risks, and make the decision within the framework of your own plan, diversification and horizon.
Note: The information contained in the text is for informational purposes only and does not constitute an investment recommendation, information recommending or suggesting an investment strategy within the meaning of applicable regulations, or any other form of advice regarding the purchase or sale of financial products.
