Merrill Lynch and the Rating Game

Merrill Lynch has probably absorbed more criticism than any other old-line Wall Street firm for supposedly hyping worthless stocks for the benefit of its investment banking business. Late last week there was news that the firm might be tweaking its system for rating securities. The firm may just “start speaking in terms all investors can understand,” the New York Times reported—those terms being buy, sell, and hold. 

Now, a lot of people (including me) have made fun of Wall Street analysts for using multitier ratings systems that seem designed not so much to give a nuanced view of a stock’s prospects as to provide cover for the analysts when things don’t work out. A favorite example is rankings that suggest that there are stocks that are not worth a “buy,” but are worth an “accumulate,” a distinction that’s hard to fathom.

Merrill used a number system—1 being the most positive rating and 4 the least positive. (Previously it had used a similar system with five numbers.) The Merrill setup also rated stocks on two time horizons—long term and short term. So, something might get a short-term 2 but a long-term 1. The Times notes, “That change left investors to decipher ratings like ‘1/1’ or ‘3/2.’ ” Obviously a buy-sell-hold setup would be easier to understand.

But why would it be better? Certainly the simple system is quite useful in demonstrating after the fact that analysts have blown this or that call because they’re corrupt, stupid, or simply wrong. And it’s very useful to journalists, who are always on the lookout for quick and easy shorthand; in real life Merrill’s number system was always ignored and simply converted by the press and by outlets such as First Call into buy-sell-hold language. But buy-sell-hold is actually not particularly useful to investors and never was.

Apparently the reasoning of the simplicity-mongers is that it would be a great thing if analysts were very clear in telling us which are the stocks that everyone can buy and profit from and which are the stocks that everyone should sell immediately. Obviously, that’s ridiculous. There is no such thing as a stock that everyone should buy. Some people, depending on how much money they actually have, should not buy individual shares at all. (Is it still heresy to say that, or do people tend to accept it these days?) I would also politely suggest that anyone who is unable to “decipher” Merrill’s supposedly byzantine rankings also has no business putting money in stocks.

Setting that aside, even active investors have different needs and goals that make a huge difference in evaluating whether a given stock is worth owning—including what they’re investing for, how long they want to hold the stock, individual risk tolerance, and of course what other investments already make up their portfolio. The same is true for “sell” decisions, which of course depend on such variables as how much you paid for the stock in the first place, your tax situation, and so on. As for “hold,” that’s obviously a piece of advice that doesn’t mean much to those who are trying to figure out whether to buy. The point is you can’t really make a decision based only on the one-word blurting of some stock analyst, so why enhance the already absurd importance of these ratings by pretending that they’re some sort public service, like the color-coded Homeland Security Advisory System?

(One quick aside here about sell ratings—people have pointed out over and over that the big firms hardly ever issue sells. What often doesn’t get pointed out is that in many cases when an analyst becomes disenchanted with a given stock, he or she often simply drops coverage altogether. This is a neat trick that exempts analysts from having to take a negative stand. If reformers insist on sticking with buy-sell-hold, they ought to push analysts to be more public about these decisions.)

Maybe what analysts really ought to do is stop rating stocks altogether and insist on releasing paragraph-length takes on whether a given share is fairly valued or not and what sort of investor might consider buying it under what circumstances. Probably everyone would just ignore these statements altogether and perhaps with time would forget the silly notion that an investing decision can be boiled down to one word from some guy on television. Maybe someday investors will even stop worrying about whether they “understand” the lingo of Wall Street research firms and devote a little more time to understanding their own investments.