Think back a few years, and you'll remember some hand-wringing about how few stocks had been given "sell" ratings by Wall Street analysts. This was part of a multifaceted scandal that led to some reforms. One statistic shared was that fewer than 1% of stocks were rated "sell" by brokerage firm analysts. This made it clear that something was rotten somewhere -- surely 99% of stocks weren't that healthy, right? The widely accepted explanation was that the analysts were loath to wax negative about most companies because either the firms were already clients of the brokerage's investment-banking division, or they someday might be.
That made sense at the time, and still does, at least to some degree. But recently, in Slate, columnist (and former hot-shot Wall Street analyst himself) Henry Blodget offered other explanations. He noted that both "independent" research firms and brokerages alike are still slapping few companies with "sell" ratings -- significantly fewer than 10%, in many cases.
Blodget offered several reasons for this:
- First, selection bias: Since most investors invest "long" (i.e. they don't short companies) and most research houses cover only a subset of all the stocks in existence, it makes sense that analysts would focus on the healthier firms, which are less likely to command "sell" ratings. (Here's an interesting article on shorting.)
- Next, sometimes ratings are relative. He opined that when an entire industry is ailing, it does little good to rate all the component firms "sells." Instead, it's helpful to give positive ratings to the healthier firms in the group.
- Analysts are, like most of us, impressionable and psychologically predisposed to be influenced by the crowd. If their peers are positive, they may be as well. (Here's an article on the wisdom of crowds.)
- If the prevailing winds are positive, it can be extra risky to be negative. So even if you're wrong, it can be safer to stick with the popular opinions. (Gee, Wall Street is suddenly seeming a lot like high school, isn't it?)
- Being negative on a stock can lead to the company cutting off communications with the analyst, which can harm further analysis.
So what do you do now? Well, we've said it before, and it still makes sense to me: Go ahead and read analysts' reports -- but focus on all the words (and numbers) except "buy," "hold," or "sell." In other words, ignore the ratings, but consider the information.
Thanks to recent reforms and scandal settlements, there is more analyst research on stocks available than ever, much of it free from your brokerage. Brokerages such as Morgan Stanley
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.