Should you trust your broker for stock recommendations?

Buying shares requires the help of a broker or remisier to act as a middleman for the transaction to go through.

These intermediaries bridge the gap between buyer and seller and help to facilitate the flow of trades through stock exchanges.

For years, they have been an essential cog in the stock exchanges’ ecosystems, although their role has diminished in recent years with the introduction of electronic trading systems for do-it-yourself investors.

However, did you know that brokers also provide other value-added services?

Many of them help to recommend stocks to their clients to help them along in their investment journeys.

These brokers are supported by a team of research analysts that delve into a range of companies and industries.

The analyst will write reports on the company’s prospects, valuation and also come up with a “fair value” or “target price” for where he thinks the stock price will head.

So, should you trust your broker for good stock recommendations?

Comprehensive company reports

First off, we should start by explaining what goes into a typical analyst report.

When an analyst “initiates coverage” on a company, he will produce a comprehensive report known as an “initiation report” that covers all aspects of the business.

Such reports usually describe the business and how it functions, provides a summary of the five-year financials, looks at the strengths, weaknesses and catalysts for the business, and highlights all pertinent risks .

In other words, what you’re getting is a good summary and snapshot of the company and its industry, all packaged within an easy-to-read report.

This is the plus side of receiving broker reports.

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They are certainly useful in getting you up to speed on a company you may be interested in investing in.

And since such reports are written for the layman, they are also not filled with technical jargon and hard-to-understand accounting terms.

In a nutshell, the analyst initiation report is a very useful document for understanding not just a company, but also to get a broad idea of how its related industry is doing.

After the initiation report is issued, the analyst will also continue to cover the company as and when it releases any earnings announcement or corporate updates.

Your broker can then provide these update reports to you so that you are appraised of the latest developments relating to the company.

A (too) short time horizon

The core benefit you receive from reading the analyst report is knowledge of the company and industry.

However, another aspect of such reports is that the attempt to come with fair values that are generally short-term in nature.

The typical analyst report has a “one-year price target” which they expect to hit in the next 12 months!

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As you are probably aware, successful investing requires you to stay vested in companies that help to compound your wealth over years, or even decades.

A one-year price target introduces an element of short-termism and tends to promote a trading mentality.

By putting up a number on the report that’s touted as the “fair value”, such reports give the impression that the investor should sell once this “target price” has been attained.

It pointedly ignores the fact that the business could very well continue to grow both its net profit and dividends for many more years.

Thus, if you acted on the report’s stated fair value and sold off your shares, you will be missing out on huge gains to be enjoyed when the business continues to do well.

Vested interest

Of course, we cannot ignore the fact that brokerage companies themselves have a vested interest to make you transact far more than you should be.

After all, the act of transacting generates commissions and brokerage fees that help to keep the broker employed.

These fees are also partly responsible for paying the salaries of the team of analysts that are providing the very reports that you’re reading.

It is, therefore, in the interests of the brokerage house to make their clients trade more frequently.

While more frequent trading may fatten the purses of your brokers, it certainly will not assist you in your wealth-creation journey.

The brokerage fees will act like sandpaper as they are expenses that erode your investment gains and magnify your losses.

Get Smart: Take the advice with a pinch of salt

It should be clear by now: although brokers do you a service by providing you with useful analyst reports to read, their “advice” on stocks should be taken with a dose of salt.

Their motives may be altruistic, but the very nature of the brokerage industry is one that encourages churn and frequent trading.

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You probably will never hear of a broker that advises you to “buy and hold” your stocks, and for good reason too.

The bottom line is that you can accept the good and ignore the bad.

Read and absorb the comprehensive analyst reports and make up your mind on what’s worth buying for your investment portfolio.

Conveniently ignore the target prices and the nagging to get you to trade more frequently, and your investment portfolio should do just fine over the long-run.

This article was first published in The Smart Investor. Disclaimer: Royston Yang does not own shares in any of the companies mentioned.