What do City analysts actually do?
Ed Bowsher looks at the role of City analysts and reveals when you should listen to them, and when you should ignore them.
Hi. In this video, I'm going to look at city analysts. Now, you may have read about them in the press, but not be quite sure exactly what they do. So, I'm going to look at what their role is and whether they actually matter to the likes of you and me to private investors.
There are two main types of analyst. You have the buy-side' analyst and the sell-side' analyst. We'll start with the buy-side analyst. The buy-side analysts work for the big investors, for the fund management companies, for the pension funds, for the hedge funds. And they spend their time analysing and evaluating companies.
They look at the financial information, they look at how profitable a company is, how much debt it has, how much cash it generates. And the analysts will also look at the prospects for that business, and they then give an investment recommendation to the fund manager. The fund manager can then decide whether to buy shares in that company for the fund.
So, that's why buy-side analysts have that name they're analysing for the buying process. They work for people who are buying shares, such as the big investors, and the fund managers.
In some ways the sell-side analysts are very similar to the buy-side analysts. Just like the buy-side guys, they spend their time looking at all the financial information that a particular company produces: all the profits, the debt, the cash, etc. They also look at the future prospects for any particular business. They don't just look at individual companies, they also look at sectors.
You might have a sell-side analyst covering the UK retail sector, or the European construction sector. And these sell-side analysts normally work for the big investment banks in the City or for the stock brokers. They're called sell-side analysts, because they're effectively selling shares to the big fund managers and the big investors.
So, let's just look in a bit more detail at some of the work the sell-side analysts do. There are four main components of the output. First off, you have the ratings. This is the classic stuff that you'll read about in the press. Buy. Sell. And you'll all have heard of hold' and reduce' and accumulate'.
Then the analysts also write notes and reports. They might write a fairly short note on an individual company. Or they might do a longer report perhaps on a company or a sector such as the UK retail sector that I mentioned. They'll then look at the prospects for the UK retailers across the board, and also identify the most attractive retailers as potential investments.
The third output is what I like to call IPO [initial public offering] support'. So, when a new company lists on the stock market, say, Facebook in the US, you'll get lots of analysts talking about the prospects for that company both in terms of reports, but also talking to fund managers, potential investors and the press. Often the analysts will be employed by investment banks, who are helping Facebook with their IPO.
The fourth thing that the sell-side analysts do is produce forecasts. If you were thinking about buying shares in, let's say Tesco, you'd obviously look at how much profit they made last year, and the year before, and a few years before that.
But it's also good to know how much profit Tesco's going to make this year and next year. An analyst's forecast can give you a figure as to what Tesco's profits might be over the next one, two or three years.
That's all very well. The problem is, you can't necessarily believe all the things that the analysts put out. There are two real reasons for that, and it all really links back to how sell-side analysts are employed and how they're paid. I said earlier with sell-side analysts, they're employed by the big investment banks and by the stock brokers.
Let's have an imaginary bank. We'll call it "JW Goldman". And let's also have an imaginary retailer. We'll call it "Tesburys". Now, JW Goldman might have a close relationship with Tesburys. Actually, last year, Tesburys bought a Spanish supermarket chain, and JW Goldman, as an investment bank, helped Tesburys make that purchase.
It acted as a financial adviser and doing that work was very lucrative for JW Goldman. So, they don't want to fall out with Tesburys, and they want to be involved in any future deals that Tesburys may do. For example, Tesburys might decide to issue some new shares or bonds to raise cash for investing.
So, JW Goldman doesn't want their analysts to be too critical of Tesburys. That applies regardless of whether JW Goldman is currently an adviser to the retailer. Even if a bank isn't an adviser right now, they're hoping to be an adviser in the future. That's why there's this huge question mark against the impartiality of sell-side analysts.
As a result, you really can't take the buy', sell' and hold' ratings too seriously. Especially the buy' ratings, because there are way more buy ratings out there than sell ratings.
As a journalist, I've read many notes and reports over the years. And they can be useful. They can help you understand the business model of the company in more detail. And that's because the analysts gets lots of access to the company directors so they understand how the company works.
But equally, I've read loads of reports that have been proven completely wrong by events, and I think that's, at least partly, because of this impartiality issue. But also sometimes because the analysts just aren't that good.
It's highly unlikely that you, as a private investor, will be able to get hold of any of these notes and reports, but don't worry about it. In many ways, you're better off without them. With the IPO support, you probably won't see the big notes that analysts put out when a new company lists. Again, I really wouldn't worry about it.
Then there are the forecasts. I actually think the forecasts are more useful and have more credibility than the other things we've looked at. They're not perfect, they're not gospel truth, but they have more credibility. I think the important point is that Tesburys is a big retailer, and it might have as many as 20 analysts following it. They will all give their own individual forecasts for profitability over the next two or three years. Average out those forecasts and you get the consensus forecast figure.
That consensus forecast figure is useful, is reasonably reliable and it's also been widely used across the City. So you, as a private investor, when you start your investment process, know what figures the rest of the City are using, and they can be at least fairly reliable.
The good news is it's really very easy for private investors to get hold of these consensus forecasts. You can find them on websites such as FT.com, Yahoo Finance and several others. You just go and look at the financial reports, the financial information and you won't have to look very hard to find consensus forecasts for profits for next year. As I say, they're worth following.
I think the other thing you need to bear in mind when you think about what the sell-side analysts are doing is not only whether they are under pressure to help the big banks get financial advice work, but also whether the big banks will do the buying and the selling for the investment funds, and for the pension funds.
Every time they buy and sell a share for a pension fund, they get a cut commission. So the banks and the stock brokers like to encourage the investors to buy and sell shares as much as possible.
The analysts are part of that process of encouraging investors to buy and sell, and really that's a dumb idea. You don't want to overtrade as an investor. So that's another reason I think why there's a question mark over, really, a lot of what the sell-side analysts do.
Just as a final point, so far we've only been looking at analysts who cover equities, who cover stocks and shares. There are also analysts out there who cover debt, who cover government debt, and also debt by individual companies.
Some of these analysts work for the ratings agencies such as Moody's and Standard & Poor's. I think the financial crisis really dealt a massive blow to the credibility of those credit analysts, so don't pay much attention to them.
As a private investor, they're not really that useful. You're more likely to be focusing on stocks and shares equities.
When you're looking at equities, the most important analyst is you. Do your own analysis, and believe in your own analysis. If you do that and stick to your guns, I think there's a good chance that, actually, you'll perform pretty well.