Who Will Rate the Raters? The Analyst Crisis on Wall Street.

We here at Don’t Quit Your Day Job are sometimes a cynical crew.  We have a keen sense of the absurd and love to share the most egregious absurdities with you.  You see, there is a position on Wall Street called a Financial Analyst – and those Analysts are trusted to do a very fundamental job: break the investment prospects in various companies down into one of 5 categories.  There are positive categories (like buy or overweight), neutral categories (like market perform, market weight or… neutral) and negative categories (like sell and underweight).  Different firms have different ratings, but all ratings fall into one of those three bins.

“Quis custodiet ipsos custodes?” roughly translated means either “who will watch the watchers?” or “Who will guard the guards themselves?”.  Usually the phrase is employed to point out instances of police brutality, but it is relevant in this situation as well.  Financial Analysts have an important position – millions of market participants rely on their words and changes in analyst ratings can move the market for a particular stock.  The main problem with analysts?  Their incentive structure – analysts tend to be employed by large Wall Street firms.  Those firms have lines of business other than recommending stocks to investors – issuing new stock or bonds, general financial services, initial public offerings and various other categories of financial work.  Therein lies the conflict of interest: putting a negative rating on a firm might get your financial company blacklisted from doing business with the firm in question.  So, even though there may be a universe of stocks which nobody should invest in, Analysts are constrained during their ratings because the firm they are employed by is still interested in getting business from those very companies!

Chart of Analyst Equity Ratings - Buy, Overweight, Neutral, Underweight, Sell

Analyst Equity Ratings (Wall Street Journal / FactSet Research Systems)

 

The Drift of the Negative Rating When It Comes to Stock Ratings

“Don’t shoot the messenger” is another good quote that comes to mind when discussing this issue.  However, it applies to Analysts that go against the grain and downgrade a company.  Sure, there is some market reaction due to the downgrade itself, but for an Analyst to actually make a downgrade there is usually a very good reason to make the call.  One of the more famous calls in recent years was from Meredith Whitney, when she wrote a bearish note on October 31, 2007 about Citibank.  However, as reported in the Wall Street Journal (and her own words), it wasn’t even a difficult call to make.  The jury is still out on her second most famous call – a negative report on Municipal Bond defaults which hasn’t (yet?) been accurate.

Like Whitney said, deciding that a firm’s prospects were negative was the easy part.  Navigating the politics of a downgrade was the hard part.  Consider her Municipal Bond call – the ‘company’ that issues Municipal Bonds is usually a government, or at least government backed.  Note that after her call that municipal Bonds were weak she was actually asked to appear before a Congressional Panel – talk about powerful dissuasion to say anything negative about Munis!

Good, Good, Good, Good and Okay Stock Investments

Realistically, some investments will always perform better than others.  A combination of market trends and smart management ensure some companies will be winners… and some will be losers.  This leads us to the analytical aspect of this piece – how many companies should have a negative rating?

It’s an impossible question to answer.  The ideal number of negative ratings is obviously non-zero.  Since the drift rate of stocks has been historically positive, it’s likely that there should be more positive ratings than negative ratings.  However, in practice, the bias against negative ratings is incredibly strong.  From the Wall Street Journal, which excerpted Mike Mayo’s book Exile on Wall Street, (Mike’s Book’s subtitle: “One Analyst’s Fight to Save the Big Banks from Themselves”) comes this disturbing statistic: of the 29,469 Analyst Ratings tracked by FactSet Research.. only 1,212, or 4.11% were negative.

Here’s my point: don’t listen to stock Analysts when you make investments.  Their incentive structures dies them to the firms they track, rather than the investors who listen to what they say.  So, readers, what’s your opinion of Financial Analysts?

Comments

  1. says

    I think they’re terrible, no good people, of course!

    My own biases aside (as equity research is what I would like to do for a living) I think it’s important that people seek out multiple sources of information. If you fear the connection between analysts and revenue generation, you might be inclined to seek out third-party analysis from a company like MorningStar. Alternatively, there are a few sell-side shops that do not have investment banking operations yet maintain an equity research division. (One that comes to mind is Hilliard Lyons, though I know there are a few others.) 

    You can look up the rankings for analysts in any given year at the Wall Street Journal. Here’s the list of the 2011 best analysts. Not surprisingly, there are quite a few people who lead their respective category year after year. So, if we let history be our guide, then perhaps follow only the multi-year winners. Getting on top of the rankings a few years in a row is proverbial gold for a career in equity research, so there’s a lot of incentive for analysts to make the right calls. Then again (sorry Occupiers!) compensation in research isn’t even close to what it used to be. The days of multi-million dollar bonuses are gone forever, it seems.

    That chart of “Buy” and “Hold” ratings is pretty concerning. Maybe Mr. Bennett is right…seems like Wall Street really does like Buy and Hold. ;)

    • says

      When I last used Morningstar equity research (vs. S&P or others), it was horrible when compared to the field. They admitted in some publications to the fact that their methodology on stocks wasn’t yet what it should be….have they improved recently? If not, I don’t want to use Morningstar for stocks. I’ll stick with them for mutual funds.

      • says

        They must have gotten better. I won a giveaway at Investor Junkie for a MorningStar premium membership. I like their analyses, and I use their 5-star stocks as a screener of sorts to do my own analysis on firms. Even among their 5-star picks, I really only like maybe 5-10% of them. I’m picky though, others may find the whole list to be attractive.

        I like the membership most for 10-year financial data. It’s great to be able to run an analysis with 10 years of past history. 

    • says

       Buy side or sell side for yourself?

      I’ve got to tell you I pretty much ignore the ratings on stock I sell.  I’m more interested with the activity on the message board and the opinions on Fool and Marketwatch than the opinions of the raters.  I do take a look at recommendations to see what they are predicting for earnings growth over the next few years (which, incidentally, lets me know how the market is valuing the stock).

      Maybe they should bring back the million dollar salaries and you can go shake things up at an independent?

      • says

        Buy side. That’s where the money and the exit opportunities are. Also, sell-side research is…okay, but you have to remember that your audience is average investors, not institutionals. If I had to make a pitch to an investor, I’d prefer to make it to people with an academic understanding of finance than ordinary investors. Seems easier, IMO.

        Bring those million-dollar bonuses back, baby! I only need a couple of those to do my own thing. ;)

  2. freeby50 says

    This is kind of like grade inflation.  If every student gets nothing but A’s and B’s then a 3.0 is not very good and a 3.5 is kinda average.   For stocks if almost all stocks get nothing but sell or hold then anything but lots of sells is bad.  

    re: Whitney “The jury is still out on her second most famous call”

    The case is closed on Whitneys’ supposed bond armaggedon.   She was completely wrong.  She claimed we’d have 100′s of billions in defaults within 12 months in Feb ’11.   That definitely did not happen.  Her mistake in playing nostrodams on TV was that she put a time limit on her scare mongery armaggedon prediction.   Smarter pundits know to be vaguer about timeframes so you can’t nail them down on their failures.

    • says

      On grade inflation – is it a huge deal at a place like Harvard, where everyone is way above average?  Is it fair to students at other colleges who perform to the same relative level?  Tough questions!

      Yeah, lesson learned for Whitney, I hope.  As something approximating a value investor, I know that when I make a stock purchase I don’t have an exact time frame in mind for holding the stock – I tend to not make predictions with an expiration date, heh.  Maybe I can be a pundit?

      • freeby50 says

        I think the problem with grade inflation is not between one college versus another.  From what I gather grade inflation is a common thing across all colleges.   Where grade inflation is a problem is for the students and anyone using those grades as a meaningful indicator of the students success.  From the student side, how do students really excell or challenge themselves if everyone is rubber stamped with an A+ for anything but failure?   It undercuts the education process.   On the side of the employer, how do you sort resumes if every student has a 4.0?   Of course grade inflation is not that bad but its actually pretty similar to the chart in your article here.   Its almost all A’s and B’s now and very little below that.  B’s are the new C’s.   

        • says

          I had one anecdote on grade inflation way back when, but I agree with you. GPAs a probably not comparable from year to year, and probably not major to major. 2.5 in one major versus 3.5 in another? You have no basis to say who is relatively better compared to the other students if the scales are different.

          I bet we’ll see more pass/fail type systems. Already a lot of MBA programs won’t give GPAs as it is – I bet it spreads to undergrad.

  3. says

    I was just about to mention the same list that JT linked to about ratings of the raters.

    Your chart says everything we need to know about many analysts.

    On a related topic: did you see the Arrested Development where they were all partying because Cramer had upgraded the family company from a “sell” to “don’t buy” rating?

  4. says

    The stock market always fluctuate it is not stable.Before investing should see the rating of the company and the ranking from the analyst and the last comes our view which is also important.

  5. says

    Everything about WS screams conflict of interest.   As JT mentions below, we can appreciate the data provided by a premium service, or even the basic S&P reports provided by a brokerage.  But analyst recommendations?  Follow at own peril.

    • says

      Yeah, I do find the “Chinese Wall” to be sort of a joke. Who really believes that if someone is about to flip to a negative rating on a company while the bond department is helping that company issue debt they aren’t going to hold it? Also, 1,000,000 other similar situations that would take way too long to list, haha.

Trackbacks

Leave a Reply

Your email address will not be published. Required fields are marked *