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Opinion Rating Systems Are Misleading

Even if the Street’s investment opinions were credible, investors still would be unable to determine exactly the meaning of the recommendation. Sometimes Buy means Sell. Brokerage firms have differing stock-rating terminology that can be highly deceptive. Analysts are often forced to hedge as their investment opinions attempt to straddle dissimilar audiences. Although most firms have contracted their stock opinion format from four or five different gradations to three, there is still excessive wiggle room. The famous Neutral or Hold monikers are merely a way for analysts to hide and save face, since after the fact they can usually argue that they were accurate, however convoluted the claim. Investors have no clue what to do with such a Hold opinion. Only the highest rating in any firm’s nomenclature, usually Buy, Strong Buy, Overweight, and so on, indicates that the analyst has a favorable view on a stock. Or does it?

In the latter part of 2006, according to Barron’s, a Morgan Stanley analyst initiated coverage of Toll Brothers with an Overweight rating, the stock trading above $29. Sounds positive, doesn’t it? Well, the price target was $23, indicating his expectation of a major drop in price. Apparently, that firm’s rating meant only that the stock would do better than its counterparts in the home building industry. This was no help to investors who might have believed the opinion called for purchasing the stock for its appreciation potential. Confusion reigns.

Analysts use lower-level ratings, such as Accumulate, Above Average, Hold, Neutral, and sometimes even Buy (if the firm has a superior Strong Buy in its system), as rubrics to convey a negative stance to their key client base, institutional investors. They avoid the more pessimistic classification levels such as Below Average, Underweight, Underper-form, or Sell, in order to dodge the flack from corporate executives and those institutional investors who own big positions in the stock. It is also a way to massage investment bankers. Accumulate opinions were once referred to euphemistically as a “Banker’s Buy.” Sounds positive, but in reality it is negative. It helps the analyst save face.

The current almost-universal three-level investment rating scheme is fraught with confusion and disparities among different firms. Investment recommendation jargon needs to be clearer and more consistent throughout the Street. Does Overweight mean Buy? 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?” 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 that the stock might rise anywhere from 10% to 25% in the next 12 months. According to the Journal article, at Bear Stearns an Outperform implied that the stock would do better than the analyst’s industry coverage. At Smith Barney, a Buy connoted an expected total return of more than 15%. A Buy at UBS Warburg meant it would rise 15% or more over prevailing interest rates. Thankfully, some firms have finally gone to just one investment rating time frame, eliminating the near-term and long-term tandem that was often a conundrum. But there is a long way to go to get the industry’s investment rating systems on a similar page.

In mid-2008, a major brokerage firm shifted its policy to help bring some balance to its universe of ratings. To encourage more negative opinions, it started requiring its analysts to assign an Underper-form to 20% of all the stocks under coverage. At the time only about 5% of all Street recommendations were Sells. But confusion persists since the firm’s definition of Underperform is “the stock will either fall within 12 months or rise less than competing companies with higher ratings.” This means the stock might either go up or go down—not very enlightening.

It is 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 is hesitant to upset vested interests with the dreaded Sell word. The latter is usually the case. The Street normally interprets Hold opinions negatively. So should the individual investor.

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.

Wall Street investment advice is further blemished by being risk adverse. Obfuscating is pervasive, stemming from 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. This is equivocating. In a simpler system, the analyst might carry only the Neutral recommendation. That way, he can dodge responsibility no matter how the shares perform. If the stock spirals lower, you will hear, “I was not really recommending it.” Conversely, if the shares climb, there will 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, credit will be taken for those stocks that ascend. A ready excuse is offered for any of those whose prices meander, that the name was not among the top two or three best picks.

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 that 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 at the same time in pacifying relationships with institutional holders and corporate executives. Forget using Buy/Sell—too crass, politically unacceptable. Under such a simple system, the analyst view on the stock would be more clearly communicated, and the accuracy more readily tracked. But do not expect this to ever happen. Wall Street would never deign to be that accountable.

For the sophisticated institutional audience, I would go a step further, and remove investment ratings altogether. 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 could lower an opinion without incurring the wrath of big holders and corporate executives.

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 might have 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 out of favor and not being widely recommended, that represent value, and that might eventually attract opinion upgrades.

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