October 22, 2015

Question: Why There Are Few Sell Ratings On Wall Street

Why are there so few sell recommendations on Wall Street?

This has been a matter of much debate in the media, and with good reason. Read on and discover the answer to this popular question - you may be surprised!

Bull Market Explanation
The current view is that analysts tend to be wildly optimistic and possibly criminal in how they rate stocks during a bull market. Researchers have published data showing that, during the late 1990s, sell ratings were as scarce as value investors. And while the ratio of sell ratings to other ratings has increased since then, the sells remain in the minority.

Research Requires Compensation
The reason there are so few sells is that it is not economical to follow a stock with a sell rating. Providing research coverage requires a large investment of time and money. In order to remain profitable and cover the cost of providing research, brokerage firms need to be able to make money on transactions made by customers trading the stock or get investment banking business. A stock that is going up has the potential to generate profit for researchers because investors may buy the stock many times and will need more information throughout the time they own the stock. A sell rating results in just one trade.

Historically, it was a very rare occurrence to find research initiated on a company with a sell or hold rating because the cost of initiating coverage is not justified by the potential revenue of that research coverage.

Coverage is usually initiated and maintained on companies that have the potential to be long-term winners, thereby generating income for a longer period than it took the brokerage to initiate coverage. Of course, investors want to buy stocks that are expected to rise, sometimes several times, which generates fee income that (hopefully) more than offsets the brokerage's cost of providing that research.

When Sell Ratings Are Issued
Sell ratings are issued if a company's profitability starts to falter or if it has issues that indicate that its stock is no longer a good investment. When a company reaches such a point, its stock may be placed on a monitor status, at which time fewer reports are issued, if any. Indeed, the brokerage is more likely to quietly drop the stock and publish no further research.

However, in a post-Spitzer Wall Street, there is a new game in town and it's called a quota system.

Brokerage firms are now required to have a certain percentage of sell ratings. While this is meant to prevent future abuses, it actually increases the operating costs of brokerage firms and, possibly more damaging, regretful research on firms that previously had no coverage.

Regretful research is the result of analysts trying to increase their number of sells (to keep up with their quota) by finding some small/micro-cap firm and doing a brief report on why it is not a good investment. The method and motivation behind this research is regretful because it may not be in depth, stemming from a desire to meet the quota rather than a commitment to providing investment information. The unlucky company used to fulfill the sell quota could be in the early stages of improving profitability and may be a great long-term investment, but the superficial sell rating assigned to it will taint it and keep investors away because it is likely to be the only research on that company.

Investors want to know more about stocks that can go up and not so much about stocks that might go down. To meet this demand, analysts spend more time looking for stocks that will go up than analyzing stocks that may or will go down. This market dynamic can be summed up by two classic Wall Street sayings:

An analyst is only as good as their last idea.

A stock can be bought many times but sold only once.

The quota system may do more harm than good because it encourages research that, regretfully, may not present an accurate analysis of a company's investment potential.

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