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Goldman Sachs this week became the latest investment bank to prod its equity analysts off the fence by banning the stock recommendations “outperform” and “underperform” on the grounds that they are not very informative. It is now insisting on unambiguous “buy” and “sell” tips, for which its number-crunchers will be held accountable.

There are thousands of analysts whose job it is to issue reports and recommendations on specific stocks. They look at company fundamentals and then build financial models in order to project future trends. They then use these projections as a basis for issuing recommendations on whether or not they think the stock should be bought or sold.

What sort of tips do they provide?

Recommendations vary according the methods used by individual investment banks. But a “buy” or “sell” indicates that a share price is expected to move up or down more sharply than the rest of its sector. Other terms such as “outperform” or “underweight” refer to less sharp movements in a share price and would be used typically if a share was expected to rise or fall by less than 5 per cent compared with its sector. “Accumulate” and “reduce” suggest a more gentle movement in the share price is expected.

Can I rely on these tips?

Many investors take these recommendations seriously, and you’ll notice that often when an analyst changes his or her outlook on a stock the price will rise or fall immediately. But investors should be wary of accepting any recommendation as gospel. Strict separation is enforced between the different departments in the banks. But the suspicion remains that some analysts suffer from a conflict of interest between the firm that employs them and the company which they track. An analyst will often have to issue reports on a company that is a current or potential client of their employer.

What about the recommendations themselves?

That’s another area to be careful of. There are very few “sell” recommendations issued; “buy” and “strong buy” are much more common. Only one in 10 recommendations issued are “sells”, according to a recent survey. Some investors interpret a “buy” as meaning a stock that is not good enough to be a “strong buy” so in reality not worth buying at all. Also, some investors are suspicious that analysts may put a positive spin on the gloomiest of stocks because they do not want to offend any company that could be a potential client for their bank.

What other recommendations are there?

In addition to issuing “buy”, “hold”, and “sell” recommendations, analysts also issue earnings estimates for companies. These estimates have become increasingly important as companies that “beat” the estimates typically see their stock prices rise while those that do not usually watch them fall.

Is there anything to be aware of here?

The analysts’ earnings estimates depend on information provided by the companies that may be subject to manipulation. In an all-too-
common practice, companies will guide analysts towards earnings numbers that are lower than the company actually expects to report. As a result, companies will then exceed expectations, which unwary investors look at as a sign to buy.

How often do analysts get it right?

Tellingly, this sort of information is much easier to get hold of than research showing the number of times that analysts get it wrong. Starmine, the analysts’ rating service, analyses data collected by Thomson Financial and tracks every “buy” and “sell” recommendation made by analysts as well as every change they make to company profit forecasts. It cites Merrill Lynch analysts as last year’s best big company stockpickers, just beating their competitors Goldman Sachs and Morgan Stanley.

What about analysts that get it wrong?

Starmine does not publish this data because it says it is not as useful for investors. But investor website Digital Look has surveyed the buy and sell recommendations of the City’s leading equity analysts. Although it does not name and shame analysts, it did find that the advice is often a waste of money.

Can I do my own research?

Websites with information on shares include Motley Fool, ADVFN, TD Waterhouse, Starmine, Citywire, Hemscott, Comdirect and WhatInvestment. Many of these provide a round-up of share tips every day with whole sections devoted to those stocks that have had the biggest gains and falls in values as well as company news, sector reviews, recommendations, new issues and a round-up of press stories and economic news.

Motley Fool also has an active discussion board as investment ideas are shared. There is greater emphasis on analysis and opinions about shares on Motley Fool than on some of the other sites.

What about stockbrokers?

Hargreaves Lansdown offers free basic online courses for investors with subjects ranging from investing in smaller companies, when to sell, company reports and accounts and portfolio management.

Killik & Co also provides a lot of useful information on shares and will e-mail investors information on stocks that they are interested in.

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