Without proper disclosure, how useful are research reports?

Source : Business Times – 16 Sep 2009

IN A Monday report on the property sector issued before the government’s anti-speculation real estate measures were announced in Parliament, a foreign broker said it was positive on stocks of developers because not only was Singapore in the early stages of a residential sector upswing, but there were also no indications that the government would do anything to derail the recovery.

In the various ‘buy’ calls on Genting Singapore which were issued during the stock’s run-up over the past six weeks or so – some of which went so far as to describe the stock as potentially being worth $2 to $3 – not one drew attention to the fact that the company had yet to announce a profit. All instead relied on the promise of possible riches available from the start of casino season in Singapore next year, based mainly on forecasts from the company’s management.

When formulating its calls for various blue chips, a foreign broker employs long-term forecasting models which project cash flows or ‘value creation’ for a period of up to 10-18 years, ie, up to the year 2019- 2027. Details of the model, however, are only given deep inside the report and are, in some cases, sketchy.

There’s more, but by now a common thread should be obvious – because of the rebound in equity markets since March, rising complacency in the financial markets has led to increased exuberance in the broking community. This in itself is fine – in an upward, frenzied market, investors are typically hungry for ideas and there’s nothing like a juicy investment story with a high target price to stir the senses.

And it could well be that notwithstanding the government’s measures, stocks of developers will perform as projected, or that Genting will reach $2 or $3 because millions of gamblers will flock to Sentosa, or that the world in 2027 will turn out exactly as expected, and today’s forecasting models that purport to peer that far into the future will then be wholly vindicated.

But there has to be a proviso and it is this: houses should be free to make whatever recommendations they want – provided all material disclosures are made upfront so that readers are properly equipped to make informed judgements. This is not the case now and until this is addressed, analyst reports lack credibility, should be viewed with a large dose of scepticism and are therefore not really that useful as decision-making inputs. This is an unfortunate state of affairs because investors should be able to rely on strong, credible research which in turn should be the foundation on which stockbroking is built.

The first important disclosure is the track record of the recommending analyst and whether he, she or their families own shares in the companies that are the subject of the recommendations. This information should appear on the first page for easy reader access; however, the current practice is not to include any information on track records while share ownership details – or the absence thereof – always appear in appendices and are usually in fine print as if they were simply incidental information.

Are track records important? Consider that when it comes to the ‘buy’ side of the business, ie fund management, there are ample sources of data on past performance to help prospective investors decide with whom to invest. Fund managers actually use this to their advantage to market their services; yet oddly, the same cannot be said of the ’sell’ side, even though it represents an equally important component of the investment equation.

Some might argue that the past may not be a good gauge of future returns – as the hapless clients of convicted fraudster Bernard Madoff would readily attest – but in a disclosure-based regime, this should not be a consideration at all. Instead, investors should be given as much pertinent information as possible and left to decide for themselves. And it’s a sure bet that no investor when presented with a ‘buy’ or ’sell’ report would ever say that information on the recommending analyst’s track record was irrelevant to that report’s efficacy.

The second area is the existence of any commercial relationships between the issuing house and the company being covered which, if made public, would compromise the impartiality of the recommendation.

To use a hypothetical illustration – in the case of the property example above, would it be useful to readers to know if the house in question also handled a large corporate finance deal for a major developer sometime within the past year? Again as in the earlier example, it’s a sure bet that if investors were polled for their opinion, the overwhelming answer would be ‘yes’.

Will investment houses seize the initiative and make the necessary disclosures to enhance their credibility, or will they continue to hide behind excuses and disclaimers? Sadly, the answer is also ‘yes’. Which can only mean that until disclosures improve, research reports must be viewed, at best, as having only limited usefulness.