The Procedure of Forming an Investment Portfolio Based on the Analytical Recommendations of Investment Banks: Evidence from the Russian Stock Market

<p>In this paper we study the mechanisms of formation and use of analysts&rsquo; recommendations regarding the prospects of Russian companies. The analysis is carried out for three major Russian companies: Gazprom, Sberbank and Lukoil, during the period from 2004 to 2014. The aim of this study is to determine the value of analytical recommendations in the Russian stock market and the possibility of using them in the process of portfolio formation. Thus, there are two objectives of this paper. First, the identification of the mechanism of recommendations&rsquo; formation based on prices and other financial and non-financial indicators. Second, selection of the optimal procedure of forming the investment portfolio within a certain class of procedures that use recommendations. It was found that the formation of the recommendations of the different companies is influenced by different factors; furthermore, the key factor is the overall financial condition of the company.</p><p>Moreover, we formulated the process of building a profitable investment portfolio, which is based on the principle of following analysts&#39; recommendations. In this study we suggest 6 ways of portfolio construction, and each of them has different restrictions on the value of the recommendations and the functional form. In addition to the linear functional dependence of the weights of shares in the portfolio on the recommendations&#39; value, we offer quadratic dependence, which is more resistant to changing the borders of the analyzed period. Moreover, the use of the MICEX index has allowed us to offer a reasonable mechanism for switching between strategies.</p><p>We came to the conclusion that the value of analytical recommendations should not be questioned, as there is an adequate way to describe the numeric value of recommendations by specific indicators of the company, i.e. recommendations carry comprehensive information and can be a good signal for investors. Moreover, the strategy of recommendations&#39; usage which is proposed in the paper, not only describes the phased behavior of the investors in the financial market, but also allows to create a profitable portfolio, which exceeds the portfolios composed by standard methods.</p>