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When an Opinion Is Lowered from the Peak Rating It Means “Sell”

Any stock rating below the highest level connotes an analyst’s pessimism or cautious stance. An analyst opinion change from the top level is tantamount to a literal Sell recommendation. Maintaining the top long-term classification while reducing the near- or medium-term view is another decisive communication of a gloomier opinion. And one should totally disregard all “long-term” ratings. They represent another analyst dodge.

The current almost universal three-level investment rating scheme is fraught with confusion and disparities among different firms. The Wall Street Journal asked, in an article discussing a National Association of Securities Dealers (NASD) study, how ratings were applied. “Is an underperform stock in an outperform industry more attractive than an outperform stock in an underperform industry?” For sure, the jargon defining investment terms needs to be clearer and more consistent throughout the Street. Does Overweight mean Buy? Recommendations can be absolute or relative. Analysts can cite accuracy with a positive opinion if it outperforms an index or the market, even if the stock declines and investors lose money. An absolute term like Buy might portray an indication the stock may rise anywhere from 10% to 25% in the next 12 months. According to the Journal article, at Bear Stearns Outperform implies the stock will do better than the analyst’s industry coverage. At Smith Barney, a Buy connotes an expected total return of more than 15%. A Buy at UBS Warburg says it’s supposed to rise 15% or more over prevailing interest rates. Thankfully, some firms have finally gone to just one investment rating timeframe, eliminating the near-term and long-term tandem that was often a conundrum. But there’s a long way to go to get the industry’s investment rating systems on a similar page.

It’s impossible to determine the level of an analyst’s enthusiasm or skepticism from the published rating. Recommendations vary in degree of fervor. Sometimes a Buy is a rather wimpy, weak, low-key endorsement. Other times, a Buy might be a table pounding, jump out of your shoes, immediate action indication. A Hold can be fairly positive, say when the analyst is in the process of gravitating toward a more favorable stance, prior to an upgrade to Buy. Or a Hold could mean the analyst thinks the company’s outlook and stock prospects are terrible, but he hesitates to upset vested interests with the dreaded Sell word. The latter is usually the case. The Street normally interprets Hold opinions negatively and so should the individual investor.

Wall Street investment advice is further blemished by being risk adverse. Opinions on stocks are hedged. This obviating is pervasive, stemming from disparate audiences and a mortal fear of being wrong. Sometimes analysts have a Neutral short-term view (this means negative) but a slightly more positive Accumulate or Above Average long-term opinion. That translates into a terrifically negative view, but it’s equivocal. If it’s a simpler system, the analyst may carry only the Neutral recommendation. That way, he can dodge responsibility no matter how the shares perform. If the stock spirals lower, you’ll hear, “I wasn’t really recommending it.” Conversely, if the shares climb, there’ll be nothing but silence. Even Strong Buy ratings carry different degrees of enthusiasm. If the analyst has six or eight companies with the same optimistic opinion, there will be credit taken for those stocks that ascend. A ready excuse is offered, that the name wasn’t among the top two or three best picks, for any of those whose prices meander.

The ideal rating system would be a two-pronged scheme to push analysts into one camp or the other. This could be positive/negative, outperform/underperform, or overweight/underweight. Notice my terms for bad stock prospects are less harsh than Sell but indicate essentially the same thing. They aid the analyst and brokerage firm in saving face, and in pacifying relationships with institutional holders and corporate executives. Forget using Buy/Sell—too crass, politically unacceptable. By setting up such a simple system, the analyst view on the stock would be more clearly communicated, and the accuracy more readily tracked. No hedging, no equivocating. But don’t expect this to ever happen. Wall Street is not that accountable.

Going a step further, and removing investment ratings altogether, may be advisable for the sophisticated institutional audience. Portfolio managers and buyside (institutional investors) analysts draw their own conclusions and make their own investment decisions. Sellside (brokerage) analyst stock opinions are an annoyance to these investors. Analysts can deliver the same value-added investment research to institutions without this distraction. Research quality and objectivity would improve if analysts no longer felt the pressure of incurring the wrath of big holders and corporate executives when lowering an opinion.

Street investment opinions are also tarnished in other respects. Wall Street loves stocks that are rising now. There is no patience to wait for future upside. It is difficult for an analyst to upgrade a depressed, languishing stock even though it may have a value. It could take too long to move. Once a stock has appreciated and “looks good on the chart,” it is much easier for analysts to get all the necessary committee approvals. Such a recommendation is more readily accepted by institutional clients, and there is less risk for the analyst.

As a result, upgrades are usually late, missing much of the rise in the stock. Boosting an opinion requires clear catalysts, evidence, and precise forecasts, all difficult to spell out early. Thus, Buys are rarely value oriented. They are momentum driven. Committees that oversee recommended lists refuse stock suggestions when the price is bumping along the bottom and shows no upside momentum. As a washed-out value, it runs counter to the mentality of the committee. Investors can outwit the Street by seeking stocks that are not in favor or being widely recommended, represent value, and may eventually attract opinion upgrades.

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