Stock-rating systems are rankings generated by analysts at stock-brokerage firms. Stock ratings are an important and controversial part of STOCK MARKET trading. Traditionally the major, full-service brokerage firms provide INVESTMENT advice to clients as part of the services offered. Stock ratings, usually ranking from “strong buy” to “strong sell” summarize the brokerage house’s recommendation regarding a stock. Announcement by one of the major firms of a change in rating will often influence sales or purchases of the stock. Stock-rating systems came under scrutiny after investigations by the SECURITIES AND EXCHANGE COMMISSION (SEC) and state attorneys general showed that in 2001, when the stock market in general was falling, less than 2 percent of the stocks rated by the major brokerage houses were rated as sell; in the previous year, only 1 percent of stocks were rated as sell. Brokerage firms are hesitant to issue sell recommendations, often because the INVESTMENT BANKING part of the firm is attempting to recruit business from the same companies, managing new-stock sales, issuing debt securities, and providing financial consulting services. The investment banking part of a brokerage firm can be quite profitable, and a sell recommendation by the company’s research analyst can cause executives to take their business elsewhere. Analysts at most brokerage firms understood that an unwritten rule was not to issue sell recommendations on companies that were important investment banking clients. This, of course, compromised the analysts’ objectivity and the information they provided to retail-stock customers. In 2002, WALL STREET leader Merrill Lynch paid a $100 million fine and agreed to separate research analysts’ pay from the investment banking side of the business. In September that same year, U.S. brokerage firms were required by the SEC to issue research ratings in terms of buy, hold, or sell. The firms’ overall research-rating system must be based on the three rankings, but individual stocks can still be rated using other terms. For example, Lehman Brothers announced a new rating-system structure that includes three tiers (trimmed down from the previous five tiers) and rate stocks relative to the analyst’s sector, not the overall market. The three rankings are “overweight,” “equal weight,” “underweight.”
Overweight: The stock is expected to outperform the unweighted expected total return of the industry sector over a 12-month investment horizon.
Equal weight: The stock is expected to perform in line with the unweighted expected total return of the industry sector over a 12-month investment horizon.
Underweight: The stock is expected to underperform the unweighted expected total return of the industry sector over a 12-month investment horizon.
Analyst teams also rate the attractiveness of their respective sectors on a positive, neutral, negative basis.
Positive: Fundamentals are improving.
Neutral: Fundamentals are steady, neither improving nor deteriorating.
Negative: Fundamentals are deteriorating.
Lehman Brothers and most brokerage firms also provide price targets, expected prices within a specified period of time, on all stocks under coverage. Goldman Sachs changed its system to rate stocks as “outperform,” “in line,” or “underperform.” Previously the company had used a five-tier rating system of recommended list, trading buy, market outperformer, market performer, and market underperformer. Credit Suisse First Boston (CSFB) changed their system to “outperform,” “neutral,” and “underperform.” Charles Schwab began rating stocks from A to F, based on a computer analysis of whether the company will outperform or underperform the overall market. In none of these rating systems do the companies use the “s” word: sell. Analysts and knowledgeable investors have long known that a “hold” rating or “market perform” rating were, in effect, a sell rating. After the new rules went into effect, the percentage of what were effectively “sell” ratings rose to 7 percent. Behind each stock-rating system is each firm’s analysis system. Most brokerage firms use a wide variety of data, including momentum, financial strength, earnings, sales volume, cash flow, price/earnings ratios, and DIVIDENDS. One company (Quadrix) uses 100 variables in seven categories to generate its stock ratings.