I was asked this question by a neophyte investor yesterday. She had just opened a brokerage account and was beginning to read investment research reports that the various investment firms produce. There was a time when you had to be a client of the firm to get this information, now most of it is available for free online.
Now think back several years now, and you’ll remember some media hype about how a few stocks had been given “sell” ratings by Wall Street sell-side analysts. This discovery was part of a multifaceted scandal that led to some major reforms. One statistic shared was that fewer than 1 percent of stocks were rated “sell” by brokerage firm analysts. But surely 99 percent of stocks weren’t that healthy, right? The widely accepted explanation was that the analysts were positive 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, one former Wall Street sell-side analyst whistle-blower 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 percent, in many cases—for these reasons:
- First, selection bias. Because most investors invest long (i.e., they don’t “short sell” 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.
- 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 many people, impressionable and psychologically predisposed to be influenced by the crowd. If their peers are positive, they may be as well.
- 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. (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, I 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.And thanks to recent reforms and scandal settlements, there is more analyst research on stocks available than ever, much of it free. Brokerages such as Morgan Stanley (NYSE: MWD), E*TRADE (NYSE: ETFC) and Charles Schwab (NYSE: SCHW) offer plenty of free research to their customers. Contact your brokerage to see what it offers.