Wall Street’s method for rating stocks is flawed. Analysts still adopt a sort of Lake Wobegon approach to the companies they follow—the vast majority of stocks they cover are rated better than average. Merrill Lynch’s proposed fix is to insist that at least 20% of stocks in any sector have the equivalent of a sell recommendation. This sounds like pessimism by arbitrary diktat. But it’s actually a good idea.
The brokerage will rate stocks as a “sell” for two reasons—either it expects them to have a negative absolute return over the following year or they will perform poorly in relation to similar companies. These are two distinct reasons. A solar energy company that is expected to return 15% over the coming year may rank as a “buy” due to its absolute return, but as a “sell” when compared with faster growing peers. So, the analysts must be clear on their reasoning.
Imposition has its benefits. It may provide some cover for analysts who want to publish negative notes. Protesting that “my bank forced me to pick somebody as an underperform” won’t prevent companies from redirecting corporate finance business to banks that publish fawning notes. But it might prevent sceptical analysts from losing access to executives.
There will be conflicts of interest. Proprietary trading operations, clients, who provide more fees than others, and banking arms can all sway analysts lacking strong backbones. But a little scepticism, even if by decree, is better than none at all.