Of market analysts and buy recommendations

"These analysts are a bunch of crooks and the worst type of crook is a crook that wears a suit and is interviewed on CNBC."
--Mitch Zacks, in the book Ahead of the Market.

If you are the kind who regularly watches one of the business news channels there is no way you can miss the analyst recommendations on stocks that keep popping up at the bottom of the television screen.

But have you noticed that analysts usually have a buy recommendation on most stocks. They rarely put out a sell recommendation on any stock. Why is that the case? To know more read on.

Stock brokerages hire analysts to write research reports. These research reports carry an analyst recommendation at the beginning. There are largely three kinds of recommendations, buy, sell or hold.

When an analyst gives a buy recommendation, he is essentially telling the investor to buy a particular stock. In case of a sell recommendation it is exactly the opposite. A hold recommendation is somewhere in between. It means an investor should neither buy nor sell the stock, but he can stay invested if he already has that stock.

Investors take these recommendations very seriously. As Mitch Zacks points out in his book Ahead of the Market, "Not surprisingly, the recommendation is probably the most widely used piece of information contained in the analysts' research reports simply because it is, at face value, easy to understand and appears to be straight forward."

And investors being human beings like things, which are straight forward like a recommendation. Rarely do investors want to get involved with the details of reading and understanding the report and then investing.

Stock brokerages need reports and analysts recommendations to keep the business going. No brokerage ever made money out of writing reports on companies. Money comes in through the commission that brokerages make when investors get onto the phone or the Internet to buy or sell stock.

As Andy Kessler writes in the book, Wall Street Meat, "Companies report earnings once a quarter. But stocks trade about 250 days a year. Something has to make them move up or down the other 246 days. Analysts fill that role. They recommend stocks, change recommendations, change earnings estimates, pound the table - whatever it takes for a sales force to go out with a story so someone will trade with the firm and generate commissions."

But why is that analysts bring out more buy recommendations than sell recommendations? There are more than one reason for the same. A sell recommendation obviously does not go down well with the company on which the recommendation has been issued. This company can blacklist the analyst and not share information with him. This obviously does not work in the best interest of the analyst.

As Zacks writes, "While most investors may forget about the sell recommendation in a couple of months, corporate management tends to have a much longer memory. When you lose several million dollars worth of stock options - as the CEO of a downgraded firm will attest - you tend to take it very personally."

The same view is expounded by Kessler. Kessler writes about one of his colleagues who had a sell recommendation out on Hewlett Packard. "He had one of those rare things, a 'sell' call on Hewlett Packard. The company just hated him. They wouldn't invite him to analyst meetings, forgot to alert him to conference calls, and would bad mouth him to institutional investors."

Most analysts are more concerned about what institutional investors think about them. The compensation of an analyst is directly linked to the views the institutional investors have of him.

And no analyst wants to upset the institutions by issuing a sell recommendation. A sell recommendation has the capability of spreading like wild fire. This can lead to a situation where everyone wants to sell out and there not being enough buyers in the market, the price of the stock can fall dramatically.

Also this can lead to the financial institution executing its trades at some other stock brokerage and the brokerage losing out on the commissions.

As is mentioned above, brokerage firms make money when investors buy and sell stocks. And what better way to make money, than to get investors to buy stocks. As Zacks points out, "A buy recommendation has more value to a brokerage firm because it gets the brokers on the phone selling stocks to new clients and opening new accounts". Hence buy recommendations, make more sense.

Investors should thus be careful and do their own homework on the stock, rather than buy or sell because of an analyst recommendation.

As Zacks says, "One of the biggest and most correctible mistakes you can make using analyst recommendations is to allow the recommendations as a means by which brokers can sell you a stock.

"You may not fully realise that the more you trade, the more money your brokerage firm makes, and that your brokers personally pockets between 25-50 per cent of the fees that you generate for the brokerage firm".