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Should you rely on sell side research to trade?

Shares in pizza delivery store franchisor Domino’s Pizza Enterprises Ltd. (ASX: DMP) plunged 9% in morning trade amid news reports that broker Credit Suisse has downgraded the stock to “underperform” from “neutral’.

According to The Australian, Credit Suisse is concerned about the outlook for Domino’s European operations that are largely focused in France and Germany, with the concerns resulting in the sell side broker downgrading profit forecasts out to financial year 2020.

Before lunchtime today Domino’s stock had already exceeded its recent daily average trading volume with 477,000 shares changing hands. This is win for sell side brokerages or the research arms of investment banks that regularly change stock ratings to underperform, sell, buy, overweight, etc, in order to encourage trading and lift brokerage fees.

Another common sell side habit is the use of “price targets”. These are largely provided to give less sophisticated investors more confidence to trade in that they are psychologically encouraged to buy or sell shares because they are above or below given “price targets”.

However, the reality is that trading based on short-term price targets or broker calls is a dumb game that can lead you to sell low or buy high while racking up the brokerage fees.

For example as a Domino’s shareholder you shouldn’t really be focused on the group’s performance over the next 12 months, or trying to second guess which way the share price might move tomorrow.

Admittedly it’s not easy, but you should try to focus on how the business will do in the next three years or more as if it’s successful in executing its growth strategy selling the stock today for 9% less than it was yesterday will most likely be a costly mistake. While the winner of course will be the brokers collecting trading fees.

Yesterday nearly 7 million Platinum Asset Management Limited (ASX: PTM) shares changed hands (around 7x the daily average of 1 million) after Credit Suisse reportedly slapped an “underperform” rating on the fund manager and a $5.25 “price target”.

Most of the broker calls or research you see reported in the local business media is happily publicised as it is all issued by the “sell side” of the local financial services industry i.e. the research arms of brokerages or investment banks that provide advice to retail clients and trade execution services in return for fees.

That’s not to say the research or opinions are not honestly held and often valid or correct, it’s just that in relying on it the only certainty is that you will end up paying trading fees.

The “buy side” i.e. asset managers themselves like Platinum or Perpetual Limited (ASX: PPT) also have large teams of research analysts, but keep their research close to their chests primarily because they want to keep their trading activities or views secret as the large volumes they trade can make it difficult to achieve the best market price.

Occasionally a buy side manger may provide research to high net worth or other institutional clients it runs money for, but this is largely to impress them with the depth of their investment processes as much as anything else.

Buy side managers also pay brokerage fees themselves every time they trade, rather then earn them when their clients trade.

Sometimes “sell side” brokerages, investment banks and research houses will provide their research to powerful buy side clients for free (in what’s known as a soft commission) in the expectation that the buy side fund managers will then use their brokerages to trade large volumes of a stock that they will have to pay fees on.

It’s this practice among others related to soft commissions that has come under attack by regulators in Europe under the MiFID II directive that demands commissions like research are unbundled in order to protect the best interests of the buy side manager’s clients who are the investors or unit holders in the funds.

After all the regulator’s job is to protect the best interests of investors, which means it should seek to ensure buy side managers obtain best execution or the best market price available at the time with their sell side brokers.

In Australia the regulator is also reportedly moving to force sell side brokers to unbundle commissions more clearly, which is placing pressure on the fee-earning potential of the industry.

In fact the cozy relationship between brokers and the dealing rooms of buy side fund managers has long been controversial as both are powerful enough to significantly move the market in stock prices – as we’ve seen Domino’s and Platinum this week.

Historically for example in Europe buy side managers may have acted on sell side research before it became public to get a little head start, while a sell side broker may get a Christmas lunch tip about a buy side manager’s upcoming intentions.

The bottom line for retail investors is that they’re often the last to know about the flows of institutional money unless they’re paying substantial fees, which is just another good reason to think twice before acting on publicised sell-side research.

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Motley Fool contributor Tom Richardson has no position in any of the stocks mentioned.

You can find Tom on Twitter @tommyr345

The Motley Fool Australia owns shares of Platinum Investment Management Limited. The Motley Fool Australia has recommended Domino's Pizza Enterprises Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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