What Analyst Ratings Really Mean

In-the-know people on Wall Street know that an analyst's "buy" or "sell" rating on a stock has many shades of subtlety. But do ordinary investors understand the code?

Stephen McClellan thinks not, and he should know. He issued more than a few of these ratings himself during a 32-year career as a technology industry analyst for Merrill Lynch and Salomon Brothers.

In his new book, Full of Bull: Do What Wall Street Does, Not What it Says, to Make Money in the Market (FT Press), McClellan says most top analysts spend about 15% of their time on actual research. They spend the rest of their time, McClellan says, on marketing activities intended to enhance their standing and build business for their employers.

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He counsels investors to use Wall Street research as industry background material and to ignore buy and sell calls, price targets and earnings estimates. That's how the pros use it, he says. Over breakfast in New York recently, we asked him for more of his insider's view of how the Street really works.

KIPLINGER'S: What, if anything, is different today as a result of Wall Street's 2003 legal settlement with the Securities and Exchange Commission that was supposed to cleanse research of its many conflicts of interest?

MCCLELLAN: It used to be the analyst would talk to investment bankers on a daily basis and help bankers bring in deals. Their research was very much influenced by whether they could do a big banking deal and so on. In other words, they worked together. It was a team effort.

That direct, heavy-handed investment banking leverage and influence over analysts has very much dissipated. Now it's very, very arms length.

However, Wall Street analysts know about every stock they cover whether their firm has an investment banking relationship and does investment-banking business. They can't help but not know that. Therefore, it still is a subtle influence in terms of a positive rating on a stock. If you're very negative on a stock, that would result in a neutral rating. It would certainly never be a sell rating because you don't want to upset the management.

Fill us in a little bit more on how to interpret "buy" and "sell" calls.

It's hilarious. You need a codebook to decode it. When a stock goes from one of those very rare sell ratings up to a neutral, that is a strong buy. When a rating is lowered from a buy to a neutral or a hold, that's a very strong sell.

Obviously, there's a reticence to ever use the big, bad s-word. There are two big audiences who object vociferously to that, and they're the biggest audiences that the brokerage firm has. They're big institutional investors like mutual funds, and they're corporate executives, which is where all the banking business comes from. In fact, only 5% of all the ratings on Wall Street are sells right now in this bear market.

Then, there's the Toll Brothers example, which is in the book. A big brokerage firm had an outperform rating on Toll when its price was $29, but the price target was $23. Well, what they were trying to say was, the stock will go down six points all right, but it won't go down as much as rest of the homebuilding stocks, which is hilarious. In that case, an outperform meant sell!

On the other hand, if there are one or two outliers that are different than the bulk of opinions, pay close attention to those opinions because they're likely to be insightful, original, creative and early. Analysts run in packs. If someone downgrades a stock because he suspects or identifies something that is negative or disturbing, it won't be long before others follow.

Do brokers who advise individual investors understand the code?

No, not much. They're almost like individual investors. In other words, they use the firm's research -- buy ratings, sell ratings, whatever -- to recommend stocks to clients. They use the firm's earnings estimates and the firm's strategist and economists and so forth, and it's the party line.

Brokers who have been around a long time at a firm have good sense for which analysts they can trust, which analysts have some credibility, which analysts are best at stock picking, and they will gradually focus on those analysts and disregard others.

I have had individuals ask me many times, how do I choose a broker? And I suggest that they get a broker who has been at the firm a long time and really knows the firm's research product and analysts because he knows whom he can trust. That's the best a broker can do.

You were on Institutional Investor magazine's All-American Research Team for 19 straight years. How good is that list at identifying the truly good analysts?

The ones who are on the Institutional Investor team do tend be best in terms of knowing and understanding their industry sector and the companies they cover. That doesn't mean, though, they are particularly astute stock pickers.

They probably know their industry in more depth than anybody, and they are probably at least average in stock picking. If they were terrible and had lot of bad calls, they probably wouldn't be ranked. The list is a reasonably decent screen of the better analysts on Wall Street, but it is somewhat of a popularity kind or ranking -- or should I say a marketing kind of ranking.

I have always contended that if you are an incredibly astute analyst spending 100% of your time doing research and doing brilliant research, with no marketing at all, you probably wouldn't be ranked on the team. If you are not out there marketing your research, selling it, talking it up, communicating it, you're not going to have any impact.

The converse of that is, if you have a pretty mediocre average -- nothing special in terms of research quality and content -- but you're really good at marketing, you can make a fairly big impact. I always thought you could take a Hollywood-central-casting actor, give him some of the basics on how to do research, and he'd do pretty well.

In your book you advise investors to own a portfolio of no more than five to ten stocks. Is that enough to have true diversification?

I don't think an analyst on Wall Street whose job is to cover an industry sector in depth can really track 15 or 20 companies. Even with a team he can hardly do it. And for an individual it's impossible.

I encourage investors to wake up to the opportunity to listen to conference calls that happen every quarter. You can listen to them on the Internet; you can listen to them on the telephone; you can listen to them two or three weeks after they happen. If you own half a dozen stocks, you can listen to most of those conference calls every quarter for one hour. You're certainly not going to do that if you own 15 or 20 stocks.

Now I don't think all half-dozen stocks should be natural gas stocks, or all should be necessarily solar energy stocks. You need diversification within that half a dozen. But I own less than six stocks, and I pay a lot of attention to them. The consensus is to own a lot of stocks and diversify. If you're going to do that, own a stock market index.