Questions need to be asked whether broker research reports are worth the paper they are printed on (or the digital space they take up in an email).
A few days before Sirtex Medical Limited (ASX: SRX) was due to release its results of its Sirflox clinical trial results, investment bank analysts from UBS released a bullish research note to clients, with a price target of $50.40.
And no, I don't know where the 40 cents came from.
But we all know what happened to Sirtex next, with shares falling off a cliff earlier this week, plunging as much as 62% from $39 to below $15 after results weren't as promising as expected.
Clearly, UBS analysts looked a bit silly and were forced to release an updated report to clients, dropping their price target to $28.75, although they still maintained their Buy rating.
But had the clinical trials been successful, no doubt Sirtex's share price would have been much closer to $50 than $28.75 and UBS analysts would've looked like geniuses.
Now, this example highlights just one issue with broker research reports. Clearly these hugely knowledgeable and intelligent analysts simply got their 'guess' wrong – and that's all a price target is after all. But it also seems their intensive research turned out to be wrong, otherwise they might've issued a Sell rating and a much lower price target.
Independent and impartial advice?
Another issue that raises its head with broker reports is a question of independence. Yes, brokers are independent from the company, but investment banks make a big chunk of their money from brokerage, capital markets and investment banking – where they are involved in things like corporate advisory, mergers and acquisitions, raising capital and other corporate finance services.
As such, they often have ongoing relationships with many corporate customers. Despite the 'Chinese Walls' that are meant to be in place between the different investment bank divisions, analysts appear loath to whack a Sell rating on many companies. Many analyst careers have been wrecked after they upset a corporate client (and their employer) with a negative rating.
As such, investors then need to question whether a Buy rating is actually a Hold rating and whether a Hold rating is actually a Sell. It certainly casts doubt on the value (if any) of broker analyst ratings.
Two-way street
Listed companies, particularly smaller ASX-listed companies also want to be able to reach investors. Arguably one of their best ways of reaching potential investors is by getting brokers, investment banks or research companies to write a research report on the company. These reports are then circulated to large fund managers and professional investors.
Many of these research reports are also posted on the company websites for investors to read. Freelancer Limited (ASX: FLN), Admedus Ltd (ASX: AHZ), Collection House Limited (ASX: CLH) and Liquefied Natural Gas Ltd (ASX: LNG) are but some of the many companies that do this.
But it's important be aware of the relationship between the company behind the report and the corporate. Would a broker write a negative report on a company that was paying them for that report?
If that did occur, would the company post it on their website or does the company only post the positive research reports, and how would you know?
Companies also need good relationships with brokers and investment banks if they, for example, want to raise capital. If a company's primary broker raises capital for the company (for substantial fees) and also writes nothing but positive research about the company, investors need to seriously consider the implications – and whether the research has been written impartially.
Be particularly wary of companies posting ASX announcements touting a broker's increased price target or rating – as we noted above – price targets and ratings can be meaningless. Companies would be better off focusing on their business, and letting the share price take care of itself.
The clear message then is as Charlie Munger says, "never underestimate the power of incentives", and be aware of the potential conflicts of interest between broker reports and their corporate clients.
