Markets

Wall Street Goes Negative

A quota for analyst sell recommendations may mean better stock research from brokers.

By Thomas M. Anderson, Associate Editor

From Kiplinger's Personal Finance magazine, August 2008

Big brokerage firms are still trying to wipe away the stain of the tainted stock research they foisted on investors during the Internet bubble of the late 1990s and early 2000s. Back then, as it turned out, some analysts hoping to win investment-banking business for their employers were praising stocks in public that they were dissing in private. Although some of the most egregious conflicts have disappeared since regulators in 2003 forced Wall Street's major players to improve their research, the system is still dubious.

Now, one of the industry's leaders has taken steps to further enhance the credibility of its research. Merrill Lynch has begun requiring its analysts to give at least 20% of the stocks they follow the company's lowest rating, the name of which Merrill changed from "sell" to "underperform." A stock with the bottom grade is expected either to produce a negative return over the next 12 months or is likely to be the worst performer in its peer group. The tweaks were designed to improve the quality and performance of analysts' picks, says Candace Browning, Merrill's president of global research.

Before the new quota went into effect, Merrill had sell ratings on 13% of the stocks in its universe. On June 2, analysts downgraded 487 stocks from "neutral" to underperform, boosting to 30% the proportion of stocks carrying what are effectively sell ratings. The massive move in opinions must have been confusing to investors who pay more attention to changes in ratings than to the ratings themselves.

Merrill analysts are now harsher critics than their peers, at least on paper. Across the industry, only 6% of analysts' ratings are sells, according to StarMine. But large U.S. investment firms have more sell ratings than the average: 19% of the stocks at Morgan Stanley have its lowest rating, 15% at Goldman Sachs, 13% at JPMorgan and Citigroup, and 12% at Lehman Brothers.

Don't expect Merrill's new guidelines to shake the industry. But maybe Merrill's new policy will bring a touch more reality to Wall Street's research machine (for more on analyst ratings, see Decoding Wall Street's Ratings).

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