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Who Will Rate the Raters? The Analyst Crisis on Wall Street.

May 14th, 2012 by 
PK

We here at Don't Quit Your Day Job are sometimes a cynical crew.  We have a keen sense of the absurd and love to share the most egregious absurdities with you.  You see, there is a position on Wall Street called a Financial Analyst - and those Analysts are trusted to do a very fundamental job: break the investment prospects in various companies down into one of 5 categories.  There are positive categories (like buy or overweight), neutral categories (like market perform, market weight or... neutral) and negative categories (like sell and underweight).  Different firms have different ratings, but all ratings fall into one of those three bins.

"Quis custodiet ipsos custodes?" roughly translated means either "who will watch the watchers?" or "Who will guard the guards themselves?".  Usually the phrase is employed to point out instances of police brutality, but it is relevant in this situation as well.  Financial Analysts have an important position - millions of market participants rely on their words and changes in analyst ratings can move the market for a particular stock.  The main problem with analysts?  Their incentive structure - analysts tend to be employed by large Wall Street firms.  Those firms have lines of business other than recommending stocks to investors - issuing new stock or bonds, general financial services, initial public offerings and various other categories of financial work.  Therein lies the conflict of interest: putting a negative rating on a firm might get your financial company blacklisted from doing business with the firm in question.  So, even though there may be a universe of stocks which nobody should invest in, Analysts are constrained during their ratings because the firm they are employed by is still interested in getting business from those very companies!

Chart of Analyst Equity Ratings - Buy, Overweight, Neutral, Underweight, Sell

Analyst Equity Ratings (Wall Street Journal / FactSet Research Systems)

 

The Drift of the Negative Rating When It Comes to Stock Ratings

"Don't shoot the messenger" is another good quote that comes to mind when discussing this issue.  However, it applies to Analysts that go against the grain and downgrade a company.  Sure, there is some market reaction due to the downgrade itself, but for an Analyst to actually make a downgrade there is usually a very good reason to make the call.  One of the more famous calls in recent years was from Meredith Whitney, when she wrote a bearish note on October 31, 2007 about Citibank.  However, as reported in the Wall Street Journal (and her own words), it wasn't even a difficult call to make.  The jury is still out on her second most famous call - a negative report on Municipal Bond defaults which hasn't (yet?) been accurate.

Like Whitney said, deciding that a firm's prospects were negative was the easy part.  Navigating the politics of a downgrade was the hard part.  Consider her Municipal Bond call - the 'company' that issues Municipal Bonds is usually a government, or at least government backed.  Note that after her call that municipal Bonds were weak she was actually asked to appear before a Congressional Panel - talk about powerful dissuasion to say anything negative about Munis!

Good, Good, Good, Good and Okay Stock Investments

Realistically, some investments will always perform better than others.  A combination of market trends and smart management ensure some companies will be winners... and some will be losers.  This leads us to the analytical aspect of this piece - how many companies should have a negative rating?

It's an impossible question to answer.  The ideal number of negative ratings is obviously non-zero.  Since the drift rate of stocks has been historically positive, it's likely that there should be more positive ratings than negative ratings.  However, in practice, the bias against negative ratings is incredibly strong.  From the Wall Street Journal, which excerpted Mike Mayo's book Exile on Wall Street, (Mike's Book's subtitle: "One Analyst's Fight to Save the Big Banks from Themselves") comes this disturbing statistic: of the 29,469 Analyst Ratings tracked by FactSet Research.. only 1,212, or 4.11% were negative.

Here's my point: don't listen to stock Analysts when you make investments.  Their incentive structures dies them to the firms they track, rather than the investors who listen to what they say.  So, readers, what's your opinion of Financial Analysts?

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