SHOULD INVESTORS BELIEVE FINANCIAL ANALYSTS RECOMMENDATIONS?

By Meziane Lasfer 

Financial analysts have always played a significant role in advising clients as to whether to buy, hold or sell some shares. For example, yesterday, Deutsche Bank issued a “buy” recommendation and kept its 1,025p target price for Compass group, a UK company, despite the firm’s underperformance relative to the FTSE during the past month due to emerging market concerns. DB argued that Compass has a good ability to deliver strong earnings per share growth, and therefore, its share price is expected to increase from its current value of 907p.  The question remains as to whether such forecasts will materialise. This is a topic that has been widely research for a number of years and views on this issue diverge significantly. Overall, the investors may need to think carefully before following such recommendations.

One might think that research analyst reports provide information about the future of the company and, therefore, they can predict future firm’s performance and stock prices. They are based on deep analysis of the firm’s past accounting data and industry and macro-economic estimates. They also contribute to making stock markets more efficient as they are expected to reveal past and future information of the firms. However, in practice their research is not reliable. There is plenty of evidence showing that financial analysts constantly make mistakes, in the sense that their forecasted earnings are significantly different from the actual earnings announced by firms consistently. There is also more recent evidence that shows that even in bearish periods when we would expect analysts’ recommendations to be better than in boom periods, the advice given by analysts is even worst, as their forecasts of profits of US companies for the next quarter is about 46% more during periods of distress than in bearish ones.

There are a number of reasons for such inaccuracies. First, it is difficult to forecast future performance because of the high uncertainty and also to value companies because the models we have so far may not be accurate. Second, there is the conflict of interest which may make analysts biased for fear of their company losing business with the firm forecasted. Third, there is the possibility that cuts in research budgets may have led to the drop in the accuracy of research in bear periods. Finally, the fact that financial analysts do not get it right (or, even if sometimes they are right, their forecasting ability is not persistent) suggests that the market is efficient, in the sense that share prices compound all available information, and only news make share prices change.

The advice that can be given to investors is not to rely lot on the financial analysis recommendations but to use as a basis for doing own research to assess fully the potential risk and return from an investment and to diversify the portfolio in order to minimise the risk.

About the Author

Meziane is Professor of Finance at Cass Business School, City University London. His research interests include Corporate Finance, Governance and Capital Markets. He has published widely in top international academic journals such as Journal of Finance, Journal of Finance and Quantitative Analysis, Journal of Banking and Finance, Journal of Corporate Finance, Financial Management, European Financial Management, and National Tax Journal. His research was widely reported in the press and was sponsored by the National Association of Pension Funds (NAPF), the Finance Lease Association (FLA), Morley Asset Management, ICAEW, Donaldsons and Land Securities-Trillium. He is ranked among the top 20 top researchers in Europe*.  Full Profile