Brokerage and investment-banking firms sell a lot of stocks. When it comes to analyst recommendations, however, the word "sell" has become an endangered species.
Irony, thy name is sell-side analyst
So-called sell-side analysts, who work for institutions that sell stocks to clients, don't like to issue sell recommendations. As I noted last fall, one study found that 95% of stock recommendations from 1993 to 2003 were either positive or neutral.
Now, in a historic realization that what goes up usually comes down, Merrill Lynch (NYSE: MER ) has conducted a study of its own. Looking at stocks from 1997 to 2007, Merrill concluded that as many as 40% of S&P 500 stocks on average dropped during any given year. This reality stands in stark contrast to analyst recommendations suggesting that suggest that only 5% of those stocks will decline.
Ban that four-letter word!
So how did Merrill respond to its close encounter with stock reality? It did two things: It put in a new rating system requiring a minimum number of negative recommendations, and it banished the word "sell" from its ratings system.
As of June, Merrill says that no more than 70% of stocks it rates will receive a rating of "buy." Neutral ratings will be capped at 30%. And perhaps most importantly, at least 20% will be rated "underperform."
By dropping "sell" from its ratings vocabulary, Merrill will rejoin a herd that was penalized a collective $1.4 billion in 2003 over alleged conflicts of interest relating to stock research. Goldman Sachs (NYSE: GS ) and Credit Suisse (NYSE: CS ) use the term "underperform," while Lehman Brothers (NYSE: LEH ) , JPMorgan Chase (NYSE: JPM ) , and Morgan Stanley (NYSE: MS ) have opted for "underweight."
Kissing the hand that feeds it
These conflicts of interest arose because of the economic realities of Wall Street firms. Investment banks and brokerages made more money from client underwriting fees and commissions than they did from analyst reports. As a result, there was a strong incentive to praise their clients and avoid offending them with the dreaded "sell" word.
For example, in 2006, a National Association of Securities Dealers arbitration panel awarded half a million dollars to a Bryn Mawr, Pa., couple who lost part of their retirement savings by trusting a "buy" rating. The NASD has suspended the analyst following allegations of favorable ratings resulting from a relationship with former Tyco CEO Dennis Kozlowski. And in 2003, Henry Blodget, one of Merrill's most notorious analysts, was banned for life from the securities industry and had to pay $4 million to settle SEC allegations.
You can cut the bull
Fortunately, intelligent investors have better options for stock research. For example, Charles Schwab (Nasdaq: SCHW ) uses its own independent rating system, in which 30% of stocks have "A" or "B" ratings, 40% are "C," and 30% are "D" or "F." According to Schwab, stocks chosen for its Equity Model Portfolio outperformed the S&P 500 by 33 percentage points from 2003 to 2007. Barron's has ranked the system among the top three in its past five semiannual rankings of brokerage share recommendations.
Merrill's decision to change its rating system, although slow in coming, is a step in the right direction. Until Wall Street stock ratings start matching up with actual returns, however, there'll still be plenty of work to do.