Research Report Red Flags For Brokers

Registered representatives are inherently in a tough situation when left to choose between selling a stock in a company for which their firm has done underwriting, and doing what is ultimately best for the client. In many cases, however, this decision is mutually exclusive. Therefore, when it comes to researching stocks, brokers must pay close attention when reading a research report, rather than just relying on the ratings their firms provide. In this article, we'll provide a breakdown of what brokers should look for and give you the tools you'll need to separate the wheat from the chaff to get the best stocks for your clients.

SEE: How To Effectively Investigate A Stock

The Temptation
Oftentimes, firms that have underwritten a particular security will look favorably on sales managers or brokers who sell these shares to their clients. In such cases, brokers may face pressure to push these shares as a result of, say, a sales contest rewarding the broker who unloads the most shares, the possibility of getting a better office in the branch or some other perk. This is where a smart broker can step in and head off any problems that may arise with the client by conducting his or her own independent research.

Key Warning Signs
Savvy brokers (and investors) should look for several key items in a research report to gauge whether or not the stock has the potential to be a winner. These items are listed below.

Excessive Rationalization and Qualifications
By definition, research reports need to show balance, which means they should disclose both the good and the bad points about a company. The methods an analyst uses to extrapolate his or her findings and generate a conclusion about a company can help readers determine whether or not that analyst's thought process was logical.

  • If an analyst describes a situation in a report and then comes up with a long, drawn out reason why it must be a positive for the company, this excessive rationalization should set off alarm bells in a broker's mind.
  • If the analyst qualifies every statement with a disclaimer, this could be a sign that the fundamental outlook is not as clear as the analyst is suggesting.

Again, a research report should be fair and balanced, but the future prospects for the company should also be obvious to the reader at first blush. Put another way, neither clients nor brokers should have to read between the lines.

Growth Inconsistent with Industry Averages
Logically speaking, faster growing companies should enjoy more popularity and a higher stock price than those with slower growth. To that end, brokers should take their analysts' prognostications lightly when they claim that a given stock will appreciate in parity or faster than its peers when its anticipated earnings growth rate actually is slower than the industry average.

Smart brokers should always look at how fast the analyst expects the company's earnings to grow over the next year - and the next five years - and then compare those with industry averages in Standard & Poor's or FactSet reports. This will help the broker to get a better sense of whether the stock is truly a buy, or will merely be a mediocre performer.

Questionable "Buy" Ratings
In spite of the Securities and Exchange Commission's focus on bringing some accountability to research departments and making certain that reports contain all of the information investors and advisors need to make good investment decisions, in many cases, rating systems remain antiquated.

Some brokerage houses parse their words by having several tiers of bullish ratings including "accumulate," "overweight," "buy" and "strong buy." This leaves brokers - and their clients - confused about the analyst's true sentiment.

For this reason, brokers must read all research reports thoroughly to get a grasp on the fundamental outlook before entering any orders for their clients. Far too often, brokers enter a buy order for a given stock for a client just because the firm rates it as a "buy," or gives it some other bullish sounding title. In many cases, these brokers have not read the report in detail and aren't really aware of the stock's outlook.

The fact is, investment banks use the word "buy" or other similar sounding words on their clients' research reports because it looks good. Big banks don't want to cannibalize their underwriting business, so they give the shares the highest rating possible and then hedge their statements in the body of the report. This is a tricky business, but it's the broker's responsibility to pick up on this and to make sure that his or her clients don't get duped.

Key Statistics Analysis
It is highly unlikely that all metrics in a given company analysis are going to be bullish. However, brokers should give greater credence to certain factors over others.

  • Insiders: Ideally, brokers want to look for companies in which insiders - such as company executives - are buying the stock. It's usually a great sign that the stock is headed higher if those running the company are buying into it. Most research reports will touch on recent insider activity - if they don't, services such as Bloomberg, and/or SEC filings will detail insider buys and sells.
  • Gross Profit: Brokers should look favorably on companies with growing gross profits (calculated as sales minus cost of goods sold). The reason for this is simple. It shows whether the company is growing its sales, as well as if it is sourcing materials for its goods effectively. Shrinking gross profits are more likely to lead to lower earnings. Conversely, a company that is showing an increase in gross profit is more likely to show a corresponding increase in earnings.

The Bottom Line
The bottom line is that brokers shouldn't take their analysts' recommendations at face value. They have a fiduciary responsibility to do their own homework and to make certain that an investment is viable in order to avoid conflict with their clients.