Follow the brokers: Buy high, sell low

I've noticed a strange phenomenon of late; brokers putting out sell notes on companies with completely bombed-out valuations.

If you watch the markets closely, you may have seen the same thing many times over the years.

This week, for example, various broker forecasts on Game Group (LSE: GMG) were quickly downgraded after the video-games retailer's disappointing update quickly wiped 50% off its value (over £30m).

So did lacklustre trading news from a High Street retailer of non-essentials really take the dozen or so brokers covering the stock completely by surprise? "Yes" is the short answer it would seem.

Now I'm not for one moment suggesting certain brokers are wrong to take such a view. An investment in Game today would be a flying punt on recovery. But the "buy high, sell low" approach so often seems to be the case with brokers.

Why wrong for so long?

It's quite legitimate to change one's view in the light of new information. But why have they been so unequivocally wrong about such a stock for so long in the face of such obviously fierce retail headwinds? After all, they're closely analysing such companies for a handsome living.

Anyone looking at stocks gets a few wrong. Hopefully, they got more right. But my Foolish colleague Alan Oscroft amply demonstrated just how inaccurate brokers are as they so often recommend the exact opposite of what we try to achieve as investors. BT Group (LSE: BT-A) was a unanimous "Buy" at 364p, but a strong majority "Sell" at 77p, for example.

As Alan concluded:

"If you're thinking of investing based on brokers' recommendations, I reckon you'd do better using tarot cards or goat entrails -- at least with those you'd get an unbiased random answer."

It's a bit like the market commentators telling us that the market looks dodgy at the moment due to Eurozone fears. What's the point? The horse has already bolted.

More buys than sells

Brokers' recommendations will always tend to the buy side of the equation, despite there having to be a seller for every buyer.

This is because they're generally paid to find investment opportunities and brokers sell stuff; analysts' reports, tip-sheets, advertising space etc. And buy recommendations have the most selling potential.

This may seem sage; stock markets tend to rise over time. On the other hand, most shares are losers. This weird phenomenon is explained by a relatively small amount of companies being responsible for the overall gains.

Issuing analyst notes is part of the service offered by a house broker. And the house broker's forecasts usually tend to be more cautious than average for a group of analysts. This enables the company to "beat expectations".

Nevertheless, you have to be cautious. Brokers are still positive on the company because they are paid to be, and because their relationship runs more smoothly if their public stance is enthusiastic. So to be safe; take the recommendation down a peg, treating a "hold" recommendation as the equivalent of a "sell" etc.

The brokers' value

Having bashed the brokers a little, it's also very important to recognise the value of their research. But it's also important to understand where they're coming from and why. The City thrives on the short-term approach, but we don't have to. So use brokers' information as part of your investment case, but never rely on it.

As Ben Graham said in the mid 1970s, long before the internet:

"In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost".

This is even more true today.

Read Full Story