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Why it pays to question broker notes

When it comes to buying stocks, screening extends beyond the company, says Lawrence Cook, director of Marketing and Business Development at Thesis Asset Management

How to spot winners and avoid losers in portfolio stock selection is one of the biggest challenges facing investors. In the context of a big universe such as the FTSE 350, the process can easily become overwhelming if a robust screening process is not put in place.

Stocks on a buy list should not be chosen on a whim nor unduly influenced by lavish corporate shareholder presentations or broker hospitality events. While broker research can form a useful starting point, investors stand a better chance of getting improved returns if they avoid relying on a single or simplistic source of analysis.

Rather than using only brokers’ notes (which are questionable in objectivity given their paymasters), savvy investors take a more scientific approach.

So what factors should be considered in terms of stock screening?

We suggest that a few quantitative and reliable measures offer a good starting point. In our case, analysing dividend yield, earnings, earnings to price, EBITDA to sales (a measure of a company’s operating cash flow), return on assets and the prior year’s total return (share price movement and dividend) gives an indication of the financial strength of the largest UK companies.

Using these factors we analyse absolute and risk-adjusted performance over a range of time periods. But an effective screening process needs to be more than just a ‘black box’ using an algorithmic-based system. Published information and data from exceptional corporate events should also be collated and given careful consideration before decisions are made. Our subsequent qualitative analysis enables us to refine the selection still further to produce a concentrated buy list and highlight potential under performers.

A sophisticated stock screening process produces some interesting results. For example, Bloomberg carried 39 broker recommendations on Tesco on 14 November 2011, the majority (28) suggested buying the stock. However, at the time, using the quantitative measures and analysis in our own model, we decided to sell at 402.4p a share. The price (at the close of business on 1 October 2015) was 178.25p.

Talk Talk is another example of a stock where properly assessing the buy and sell signals proved fruitful. We added the company to our buy list in July 2012 when shares were 171.1p. When they were put on our sell list at 322.65p in May 2014, we hadn’t caught what would be the top of the market, but we did avoid subsequent volatility.

Stocks do need to be continually monitored and performance reviewed on a monthly basis. Companies that significantly underperform should automatically be put on a watch until investors have investigated wider issues and decided on a suitable course of action.

By using the right quantitative measures and adding some thoughtful qualitative analysis of their own, investors can improve their chance of achieving long-term outperformance. It pays to think beyond brokers’ notes.

Visit the Thesis Asset Management website


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