Do brokers pick the winners?

When it comes to stock picking there are many different styles and ways of selecting the individual shares which investors feel best suit their overall strategy, target returns, time horizon and appetite for risk (assuming they feel confident enough to do this in the first place, rather than leave the job to a fund manager).

Momentum is one, where the investor decides the trend will be their friend, either on the basis that the share price is going up, forecast earnings and dividends are going up, actual profits and shareholder payouts are going up or a combination of all three. Here, valuation will be a consideration in most cases, not all, and potentially a minor one at that.

By contrast, value investors seek to poke around in the market’s darker recesses, looking for unloved, misunderstood and potentially undervalued companies where a change of some kind – management, strategy, cost-cutting, a disposal or a refinancing, for example – can spark a change in fortunes.

The momentum investor may be content to run with the market herd while the value seeker will almost intentionally go in the opposite direction. This begs the question of how to spot which stocks suit which particular style.

One way of spotting which stocks may have momentum and which do not (and could therefore be value opportunities) is to look at broking research. Granted, this is primarily intended for institutional investors but websites such as www.brokerforecasts.com and www.digitallook.com provide a summary of how many analysts cover a stock and how many rate the stock a ‘buy’ or a ‘sell’ (or are sat on the fence with a ‘hold’).

For the third year in a row, AJ Bell has analysed the FTSE 350 to see which stocks are the most – and least – popular with the brokers, to see if this could provide any pointers for the year ahead. We have also back-tested the data to see whether the most widely liked stocks (those with the most ‘buys’ or highest percentage of ‘buy’ ratings) have done well and those that seem least popular (those with the most ‘sells’ or highest percentage of ‘sell’ ratings) have done badly.

You may be surprised by the answers.

Back to the future

In January 2015, this column set out to look at which stocks were the most popular with the professional analysts, to see whether this helped identify potential portfolio winners.

Rather than just look at the crude measure of the number of analysts covering a company, we looked at how a firm’s market cap compared to the size of the crowd who were following it. After all, a big, complex company like HSBC, with a huge market cap, is always going to attract more coverage than a one-division company worth a few hundred million.

This analysis comprehensively suggested that the trend was not the investors’ friend in 2015, at least so far as the FTSE 350 (excluding investment trusts) was concerned.

Of 10 firms which had the lowest amount of market cap per analysts recommendation – in other words those which were most intensively covered and by implication most popular with the brokers – only one managed to generate a share price increase in 2015, the gold miner Centamin. The other nine all fell and between them the ten generated an average share price fall of 34.5%, way worse than the 2.5% decline offered by the FTSE All-Share over the same time period.

Most popular stocks with brokers performed horribly in 2015

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

The most over-broked stock of all, Afren, began the year with 24 analysts covering it, for just £21 million of market cap per rating – and only three of those 24 were sellers of company whose shares fell 96% in 2015 before they were suspended owing to Afren’s financial difficulties. The most intensively covered-stock, was, believe it or not the very worst single performer in the FTSE 350 last year.

That says a lot about the dangers posed by a company that has a lot of debt and whose profits are very sensitive to sudden swings in price changes in its core product – in this case, oil.

But it doesn’t say much for the quality of a lot of broking research and here the investor must be careful. No analyst wants to get something wrong and it’s no fun doing so, especially in print (and I should know as I did the job for 12 years at UBS investment bank, covering technology stocks in the UK and Europe). But the investor must be aware that analysts could be banging the drum in the in the hope they can generate commission, either from share trading or, more likely, corporate activity such as new listings, secondary offerings of paper and merger and acquisition activity.

Even if such cynicism is misplaced, the experiences of 2015 suggested that following the most over-broked stocks potentially meant investors ended up buying the most over-hyped stocks as they embarked upon a quick trip to the poor house.

Eat, sleep, invest, repeat

Emboldened by such a find, this column embarked upon the same process 12 months ago, to identify the FTSE 350 stocks which had the lowest amount of market cap per analyst and thus were the most potentially overbroked and overhyped.

In fairness to the analysts’ this time, the results were better. Nine of the ten most heavily broked stocks rose (although the only exception was the most intensively covered name of all) and they racked up an average gain of 41.3% between them.

Now that is much more like it – contrarians appear to have emerged unscathed from 2015 but on the face of it momentum ran them right over in 2016.

Most popular stocks with brokers performed much better in 2016

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

What does muddy the waters slightly is that in both years oil and mining stocks were particularly prevalent in the lists of most-intensively covered (over-broked?) stocks. Both sectors collapsed in 2015 as commodity prices sagged and growth fears gathered and both rallied hard in 2016, as raw materials prices surged and the market embraced the Trump/reflation trade.

Further test

To further probe the validity of the exercise, we have therefore dug deeper into the numbers for 2016 and gone beyond just market cap per analyst.

• We have looked at the stocks with the highest percentage of buy ratings and the smallest amount of market cap per ‘buy’ call, to see if this helps spot winners to buy (or overhyped stocks to avoid)
• For good measure, we have also looked at the least popular stocks, those with the highest percentage of ‘sell’ ratings and the smallest amount of market caps per ‘sell’ calls to see if this helps to identify worthy contrarian picks (or those that are falling knives to also be avoided).

This adds four more tests – and in three cases, doing the opposite to the analysts (and by implication the opposite to the prevailing market wisdom or consensus) would have better served the investor.

First of all, the ten stocks with the lowest percentage of ‘buy’ ratings beat the ten stocks with the highest percentage of ‘buy’ ratings hands down. Contrarians 1, Momentum 0.

The least popular FTSE 350 stocks with brokers outperformed those rated most positively in 2016

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

Secondly, the ten stocks in the FTSE 350 with the highest percentage of ‘sell’ ratings easily did better than the ten with the lowest percentage of ‘sell’ ratings. In the case of the latter, there was not one broker between them who called a ‘sell’ yet six of the ten did just that and between them they generated an aggregate loss, against the 57.6% gain for the ten stocks analysts were most keen to avoid last year. Contrarians 2, Momentum 0.

The most disliked FTSE 350 stocks with brokers outperformed those most widely liked in 2016

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

Here it then looks like the analysts are rallying. The ten stocks with the lowest amount of market cap per ‘buy’ rating – where there were loads of analysts and they were very positive – did better than those that were intensively covered and ‘buy’ ratings were harder to come by. Contrarians 2, Momentum 1.

The stocks with the least market cap per ‘buy’ rating (and thus maybe the most popular stocks of all) did do well in 2016

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

However, the good news begins and ends there for the analysts and the market consensus. The stocks with the lowest amount of market cap per ‘sell’ rating – where there were loads of analysts and they generally hated the stock – did much better where there was a lot of coverage but a relatively light smattering of bearish comment. Contrarians 3, Momentum 1.

The FTSE 350 stocks with the most aggressively negative broker coverage in still produced healthy gains on average in 2016

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

Do your own research

This leads onto the inevitable question: namely, which stocks are most liked and disliked by brokers as we enter 2017?

Before the drum roll and unveiling of the names, based on our criteria of analyst per market cap, percentage of ‘buy’ and ‘sell’ ratings, and market cap per ‘buy‘ and ‘sell’ rating, it is worth bearing the following in mind:

• On the face of it, doing the opposite to the consensus/majority broker view served investors better overall in 2015 and 2016, to show the dangers of following the herd.
• That said, the most intensively covered names with the highest percentage of ‘buys’ did do well, to suggest the trend can be investors’ friend.
• The temptation to simply blindly do the opposite to the consensus should therefore be resisted, because the past is no guide to the future and because if making money in the markets was simple every one would already be doing it.
• The data above is based on two individual years. Yet the real power of equity investing (which comes particularly through the harvesting and reinvestment of dividends) is felt over periods of a decade, two decades or more. What the data does seem to show is the well-informed, diligent, expert broking community has little more idea of what is coming than anyone else, at least in the short term. And if they haven’t got a clue when it comes to trying to time the market, it does suggest that private investors should only try it if they are only too aware of the dangers and are willing to suffer and able to financial withstand losses in their quest for momentum-fuelled portfolio gains.

Ultimately, anyone prepared to pick their own stocks rather than pay a fund manager to do it for them must thoroughly research any company for themselves before they even think about buying it shares. If this sounds difficult, well, it is but at least you can follow the lead of successful American investor Charlie Munger – Warren Buffett’s vice-chairman at Berkshire Hathaway – who boils it down to four things:

• One, do you understand the business?
• Two, does the business have intrinsic value or durable competitive value?
• Three, does management have integrity?
• Four, does the stock come at a reasonable valuation?

In other words, if you don’t understand the business, aren’t sure the company has pricing power, don’t trust the management or fear the shares are expensive, you may need to think again.

And even if the stock passes the first three tests, valuation remains a key hurdle. What could be argued here is that if a stock has done well, lots of brokers are covering it and the bulk of them are buyers of the stock, you need to have a very good reason to buy it, if the experiences of 2015 and 2016 are any guide.

As well-known American investor, commentator and businessman Jim Rogers once put it: “The more certain something is, the less likely it is to be profitable.” (Or, in other words, if the investment case is that blindingly obvious it is likely the market priced it in a long time ago).

Equally, if you like what you see, you shouldn’t be put off just because you are out of step with consensus – this means you may have unearthed a value nugget, assuming the stock passes the first three tests. Then you may be following Warren Buffett’s maxim that “You can’t buy what is popular and do well.”

Acid test

This is the third year of our analysis of overbroked (and potentially overloved, overvalued) stocks and underbroked (and potentially unloved, undervalued) stocks. These are the lists to which we shall return in a year’s time to see how they have done.

This list is simply the most intensively covered names within the FTSE 350, those with the least market cap per analyst recommendation, and then those which seem to draw the scantiest degree of analysts’ attention. It will be interesting to see which one does best in 2017.

The FTSE 350 stocks with the most coverage (and least market cap per recommendation) entering 2017

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

This next list shows the names which have the highest and lowest percentage of ‘buy’ ratings. In theory the top half should beat the bottom half – but the opposite happened in 2016.

The FTSE 350 stocks with the most (and least) upbeat broker coverage at the start of 2017

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

This third list outlines the FTSE 350 names which have the highest and lowest percentage of ‘sell’ ratings. In theory the top half should do badly and the bottom half well - except the opposite happened in 2016.

The FTSE 350 stocks with the most and least negative broker coverage entering 2017

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

The fourth batch highlights those with the lowest market cap per ‘buy’ rating and the highest amount – if the consensus broker view is correct, the top half should do well and the bottom half badly in 2017. This is how events unfolded in 2016.

The FTSE 350 stocks with the most (and least) uniformly positive broker coverage, based on market cap per ‘buy’ rating

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

The fifth and final list looks at those FTSE 350 stocks which have the lowest amount of market cap per ‘sell’ rating and the highest amount. If the analysts are right, the top half should do badly and the bottom half do well, although they were wrong in 2016.

The FTSE 350 stocks with the most (and least) uniformly negative broker coverage, based on market cap per ‘buy’ rating

Source: Digital Look, Broker Forecasts, Thomson Reuters Datastream

Russ Mould, AJ Bell Investment Director