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This chapter is from the book

Downgrades Are Anguishing, Arduous, and Rare

Analysts are reticent to downgrade opinions, fearing institutional holder retaliation. Buyside analysts and portfolio managers are most generous in voting commission allocations to the sellside analyst firms who help tout their stocks. These institutions vent their fury and banish brokerage analysts who downgrade ratings on the stocks they own. This anticipated punishment is a critical constraint when pondering an opinion reduction.

When reducing ratings, analysts come under so much criticism that our argument must be airtight. It is discomforting to reduce an opinion after the stock has already started to fade. This creates more hesitation. Like the monkey that sees no evil, we close our eyes to initial negative developments. By the time the weight of negative evidence is exceedingly compelling, most of the damage to the stock has already been done. When analysts finally capitulate and go to a full-blown Sell opinion, the stock has likely already hit rock bottom. Although patience might be required, there is usually more upside potential in the shares at that juncture for an individual investor than further downside vulnerability.

Brokerage firms have made the procedure of altering an investment rating hugely more complex for the analyst because of regulatory and legal issues. That was a consequence of the pathetic stock recommendation record after the 1990s bubble burst. Investment research committees meet at certain intervals, require burdensome reports and documentation, and grill the analyst, and then after all that, legal compliance gets involved. There is a lot of second-guessing and attention paid to current stock price trends, rather than a longer-term investment time horizon. Changing an investment opinion is a frustrating exercise. And the analyst needs to be ensconced in the office to jump through all the hoops—forget being on the road. It is just easier to do nothing. Opinion changes are hardly worth all the effort. Analysts thus resist upgrades and downgrades. Ratings that might be inappropriate remain intact out of inertia.

Early stock opinion downgrades are infrequent. Taking a negative stance and lowering an opinion is like a divorce—it might be necessary, but it certainly is unpleasant. But such dramatic calls are telling, if coming from a veteran analyst highly credible in covering the stock. After more than 16 years of superb execution and fabulous stock performance, EDS laid an egg in 1996, almost immediately after regaining its independence in a spinout from General Motors. The company’s quarterly earnings results ran across the newswire, vastly below Street expectations. My instinct told me something was terribly amiss, and my reaction was immediate. In this case, there was no prolonged torment, no deliberations, committee meetings, or soul-searching. I summarily downgraded it with no time to ponder the consequences. It was an emotional, traumatic situation, and, given my reputation and prolonged bullish view on the stock, it had a incendiary impact. The company and its shares performed pathetically over the ensuing three years. This rating drop happened so abruptly that it was actually easier to effect than most reductions. But even this good call was after the fact; the bad news had already hit. That was more than ten years ago. In this new era of heavy compliance oversight, such a quick reaction and opinion change is rare or impossible.

Sell opinions, especially if in the minority, put us on an unpleasant hot seat. If an analyst shifts an opinion to Sell, only a portion of the relatively few owners of the stock might take the advice, pull the trigger, and generate a commission. The majority of other investors do not care. An upgrade to a Buy, on the other hand, can be marketed to virtually all investors, and the potential to create transactions is expanded by orders of magnitude.

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