Wall Street Sell Ratings Even Scarcer Than Four Years Ago

A Bloomberg exclusive story reports that the efforts to clean up the relationship between equity analysts and corporate clients appear have failed to produce more candid ratings. While there is no sign of the overt corruption of the dot-com era, sell ratings are even scarcer than before, despite considerable and obvious signs of stress in certain sectors (homebuilders and financials, for starters).

But the causes show what an intractable problem this is. In the old days, securities firms were loath to assign sell ratings because it would upset companies that were or could be corporate clients. But now the issue is one of access. Public companies will simply freeze out analysts that don’t issue flattering scores, which makes it difficult for them to do their job. The proof of the pudding is that Sanford C. Bernstein, which has no investment banking business and is highly regarded for the quality of its research, is noted in the Bloomberg story as one of the firms that has held back from issuing sell ratings.

Now the SEC could fix or at least curtail this practice if they wanted to, by requiring public companies to respond to reasonable information request on a timely basis from recognized analysts, and to prohibit them from showing preference among analysts as far as inclusion in informational meetings and presentations is concerned. But that would be too proactive and pro-investor for this SEC.

The issue is that the current rapprochement is a compromise between the interests of institutional investors and corporations. Companies, particularly now that nearly all have stock-price-linked incentive schemes, do not want analysts making what they consider to be negative advertisements about their stock, even if the analysts have less influence than the companies believe. Most institutional investors have their own buy-side analysts; they read research for its information (which they may not agree with) and pay little heed to the rating. Analysts have coded ways of signaling when they are less than keen about a stock, even if their rating may not say so (and the article notes that big customers care little for the formal ratings and a lot for analysts doing the legwork of meeting with companies and reporting on them). But retail investors often are ignorant of this system and take research ratings at face value.

From Bloomberg:

Anybody who followed the advice of Wall Street’s top-ranked analysts, none of whom would say “sell” for a single company in the securities industry this year, is reckoning with subprime-like losses.

Merrill Lynch & Co.’s Guy Moszkowski, UBS AG’s Glenn Schorr and Sanford C. Bernstein & Co.’s Brad Hintz maintained either buy or hold recommendations on Bear Stearns Cos. as it fell 39 percent in 2007, the most since the firm went public in 1985. Moszkowski and Hintz had buy ratings on Morgan Stanley while the stock shed 22 percent in New York trading. Moszkowski and Schorr advised holding on to Citigroup Inc. as it dropped 40 percent.

Shrinking fees from brokerage commissions mean fewer dollars for research and more pressure on analysts to hang on to paying customers such as hedge funds. While clients care little for ratings, they covet meetings with company executives — audiences that favored analysts can deliver. As a result, “sell” ratings on Wall Street are even scarcer than four years ago, when 10 securities firms paid $1.4 billion to settle allegations by then-New York Attorney General Eliot Spitzer that they used research to improperly promote stocks.

“An analyst cannot issue a sell rating because he doesn’t want to lose access,” said Tom Larsen, a former Credit Suisse Group analyst who now runs research and helps oversee $6 billion at Somerville, New Jersey-based Harding Loevner Management LP. “It’s logistically cumbersome for the buy-side to arrange its own meetings with company management, so this concierge service is very useful.”

Analysts rarely said “sell” before the Spitzer settlement because they didn’t want to jeopardize investment banking fees. Now, they’re more concerned about maintaining good relations with company management. Only 7 percent of analysts’ recommendations have been sell this year, down from 11 percent in 2003, data compiled by Bloomberg show.

Institutional investors are willing to spend more for meetings than ratings, according to a survey of money managers by Greenwich Associates, the industry consulting firm founded 35 years ago in Greenwich, Connecticut.

Investors surveyed said they allocated 19 percent of their commission dollars to pay for “direct access to company management,” up from 14 percent in 2003. Stock recommendations merited only 8 percent of commissions, down from 18 percent.

Money managers paid brokerage firms $10.3 billion this year to trade stocks, down from $13.4 billion in 2002, even as trading increased, according to Greenwich Associates. About 40 percent of those fees go to pay for research services, including conferences and trips that allow investors to meet corporate executives….

Instead of saying “sell,” analysts have stuck with “hold” ratings that are less likely to antagonize the senior executives they’re monitoring, Larsen said. The ratio of hold recommendations has climbed to 48 percent this year from 40 percent in 2003, Bloomberg data show.

While a “hold” might be enough to signal to institutional investors that a company is in decline, retail investors follow analyst recommendations literally, according to a study published in the Journal of Financial Economics in August.

Authors Ulrike Malmendier, an economics professor at the University of California at Berkeley, and Devin Shanthikumar, an accounting professor at Harvard Business School in Boston, analyzed trading data from U.S. exchanges between 1994 and 2001. They concluded that institutional investors sell stocks downgraded to hold, while small investors react to buys and sells, but not holds.

“Companies can live with a hold recommendation,” said Larsen of Harding Loevner. “The tacit understanding by everyone, except possibly the retail investor, is that it’s a less-harsh way to say sell.”….

The U.S. Securities and Exchange Commission passed Regulation FD in 2000 to curb the practice of selective disclosure of “material information.” ….company executives can still reveal useful tidbits to investors without running afoul of the law.

“Management can still give color that will help the investor understand what’s going on,” said Richard Lindsey, a former executive at Bear Stearns, the No. 5 U.S. securities firm, who now advises hedge funds and institutional investors at New York-based Calcott Group LLC. “That’s why the conferences and one-on-one meetings analysts arrange are so valuable to this day. Even when executives don’t answer your question, what they don’t answer tells you something.”

Analysts with the most bullish recommendations are typically the most accurate at predicting earnings, according to research by professors Shuping Chen and Dawn Matsumoto at the University of Washington in Seattle. That proves that companies provide more information to analysts who make favorable ratings, Chen and Matsumoto wrote in their paper published by the Journal of Accounting Research in September 2006.

“Since Regulation FD, investors probably rely more on direct contact” with company insiders, Chen said in an interview.

For analysts, the punishment for a negative rating can be as swift and unmistakable as a door slamming shut, said Richard Bove, a Lutz, Florida-based analyst at Punk, Ziegel & Co., who downgraded the top five U.S. brokers to “sell” in July.

“At one of the companies I’ve been writing very negative things about for a while, the CEO absolutely refuses to talk to me anymore and I don’t have access to that management,” Bove said in an interview, declining to identify the executive. “And if you lose access to management, you lose the ability to take them on the road and that reduces your commission income.”….

As most analysts shy from issuing sell recommendations for fear of losing access to management, Punk Ziegel’s Bove said he has actually benefited from being the odd man out. His unorthodox calls have brought his firm new clients, he said.

“Even though they put you in the penalty box, even though they’ll call up and yell at you, whether it’s the management or the client, ultimately if your stock selection proves to be correct, you’re going to get paid for it,” Bove said.

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  1. newsman

    I’m one of the dopey little investors who help all these people support their lifestyles.

    I had wondered why so much seemed to be rated buy or outperform, with only real dogs rated “hold” or “market perform” and nearly nothing rated “turkey.”

    This article crystalizes my misgivings, and makes me wonder why I didn’t see this more clearly myself. Years ago.

    Another painful lesson.

  2. Yves Smith


    You shouldn’t feel bad. If you were ever the customer of a large brokerage, the salesmen are generally required to recommend stocks on the firm’s “buy” list. And most people come to trust their brokers, which reinforces belief in the research.

    And most of it is very well written and argued too. The system is very well designed.

  3. Independent Accountant

    The SEC could have fixed this mess decades ago. My answer: your ratings will fall as follows: 10% strong buy, 20% buy, 40% hold, 20% sell, 10% immediate sell. If your ratings do not conform to these ratios, you may not publish or disseminate them in any way. It’s that simple. Spitzer’s $1.4 billion settlement notwithstanding, sell side ratings are still useless.

  4. "Cassandra"

    Goldman again (as in their magical misplacing of email records during the last research scandal), is at the forefront of nonsense. They’ve eliminated the traditional “buy, sell, hold” monikers for an impossibly-difficult-to-fathom system of sector and absolute relative attractiveness, the sole exception being their “Conviction Buys” (note: they don’t offer conviction “sells”). More often than not, a stock being touted (in their lingo), is relatively attractive in an unattractive sector, or some such other indeterminate and contradictory combination. It is genius because the complexity and often-conflicting levels of attractiveness inherently manufacture multiple escape valves for blaming something other than their own tainted analysis.

    UBS is the least obfuscatory, quantifying their forecasted upside/downside in concrete percentage terms, though all inherent conflicts remain in markets in which IB’ing is an issue.

    The other scandalous thing NOT mentioned in the fine-print disclaimers that typically exceed in length the actual financial portion of most “research reports” (recall Bear Stearns lawyers tried to call Wayne Angell “an entertainer”!) is something like:

    XYZ Megabank makes no representations as to the nature and timing of distribution of investment research, and at its sole discretion may distribute, leak, forewarn, or otherwise disseminate reports – either in part or whole, verbally, electronically, or via whisper – any or all aspects of report contents and has no obligation to publically release on equal terms. In fact, for the avoidance of doubt RESEARCH IS ROUTINELY PRE-RELEASED TO FAVORED CLIENTS FIRST, BOTH ELECTRONICALLY AND VIA DIRECT CONTACT AND THE FIRM MAKES NO WARRANTIES AS TO VALIDITY OR FORECAST PROFITABILITY OF RATINGS OR RECOMMENDATIONS AFTER SUCH PRE-RELEASE AND SUBSEQUENT MARKET IMPACT OF SUCH PRE-RELEASE UPON PREVAILING MARKET PRICES.

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