Should you actually Buy when an Equity Research Report Rate a Stock BUY?

From the people that I speak to, there are generally two extremes. People either really believe in the equity research reports on face value or completely dismiss them.

To get the most value out of these research reports, you must understand the incentives for producing them. To start with, it helps to understand the actual business model of Equity Research.

Equity Research is a content business and therefore, don’t really generate income by itself. This is changing with the new Mifid but will take time (unbundling has been talked about for many years).

In any case, subscriptions and time costs may not really be able to justify the cost of quality research. Therefore, research or the content must be subsidised by commission income from money managers/buy side and investment banking, ie, IPO fees or primary deals like placements.

So if the bank is working on a primary deal in a particular industry, it maybe somewhat difficult for the analyst to put out a really negative note on that industry even though that maybe his/her true opinion and investors that are smart, which most of them are, they will know and appreciate that.

To illustrate, if an industry has many deals coming, the analysts will very rarely put out very negative research. In an industry that is more matured, there maybe more genuine, independent ideas. That said, there are also a number of independent research houses (mostly boutiques) with a subscription and commission model.

In the end, the content is to build a reputation/brand/following, which is then used to sell products. The analysts have a balancing between being independent, ie, protecting their own brand as an analyst and having to leverage their brand to sell the deals.

In reality, contrarian ideas are really hard to come by anyway and you need to be brave to call out a buy in a falling market especially if your job/career/family well being are all dependent on it. The fact is most analysts go with the flow because the risk and reward doesn’t make sense if they already have a following. Unless an analyst has build a reputation around being contrarian but investors will see through that nevertheless.

To sum up, the content business is about emotions and bringing your awareness to another place. For example, if your awareness is fear of loss in investing in a stock, the objective of the content is to bring your awareness to fear of missed opportunity by outlining what you are missing out on (ie, the positives of a stock but not mentioning the risks). It is a brokerage business with survival based on trades and not investment returns after all so investment returns is not the focus.

Therefore, next time you see an equity research report, don’t just focus on the conclusion but the content. The most value add of the research is whether it challenges your thinking, tells you something you don’t already know instead of the conclusion. You have to reach your own conclusions with your own research not just one research. That is something less people talk about.

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