Learn To Invest
Stocks Special Reports LICs Credit Funds ETFs Tools SMSFs
Video Archive Article Archive
News Stocks Special Reports Funds ETFs Features SMSFs Learn


Why Wall Street issues so many buy recommendations

John Rekenthaler  |  18 May 2021Text size  Decrease  Increase  |  
Email to Friend

Happy talk, unhappy consequences

Wall Street analysts are far likelier to praise stocks than to bury them. According to FactSet, which tracks the Street’s proclamations, 55 per cent of S&P 500 stock ratings are Buys, 38 per cent are Holds, and 7 per cent are Sells. The three highest-ranking analysts on a competitive site, tipranks.com, are even more optimistic. On average, those investment professionals score 79 per cent of the equities that they track as Buys, 19 per cent as Holds, and 2 per cent as Sells.

If that doesn’t worry you, it should. The facts overlay bad intentions. Frequently, companies browbeat Wall Street banks into giving them higher ratings. They threaten to withhold information; move their investment banking business elsewhere; or refuse to participate in institutional-client meetings. Their efforts are broadly successful. Analysts tend to act as my mother advised: When they can’t say something nice, they don’t say anything at all.

(Unlike the company’s Morningstar Rating for Funds, which generates a like number of 5- and 1-star outcomes, the Morningstar Rating for Stocks does not mandate a fixed distribution. However, as the Morningstar equity research group has a different business model than do Wall Street banks, it is not prone to the same tendency. Indeed, the current pattern is much the opposite. Of the around 680 US stocks that the equity team rates, only 5 (!) have 5 stars, while 83 receive a single star.)

Obviously, this result is unsatisfactory. Hidden incentives harm consumers. Patients suffer when their doctors’ recommendations are influenced by consulting fees; vacationers pay more when their tour operators receive hotel “rebates”; and investors are worse-informed when their equity analysts are affected by corporate demands. Wall Street’s equity research is flawed.

Corporate instigators

Yet… Wall Street analysts did not establish this system. Nor do they particularly care for it. Quite the contrary. They would strongly prefer that companies treated all their pronouncements equally, rather than reward their plaudits and punish their criticisms. Nor are they overjoyed by the knowledge that a harsh analysis may displease an organization’s investment bankers.

While it’s fashionable to blame investment evils on Wall Street, Main Street CEOs are primarily responsible for the state of equity research. They have the power to influence the ratings, and they have not been shy about exerting their muscle. That too many ratings are positive stems largely from the activities of corporate executives, who then decry the Wall Street “villainy” that they encouraged.   

(The public has also played its part in the process. When CEOs assail their company’s critics, shareholders frequently applaud. Such attacks target not only short sellers, which arguably deserve no sympathy, but also equity analysts who are simply attempting to do their jobs. Consider, for example, Elon Musk’s contemptuous dismissal of analysts who asked him “boring” questions about the company’s capital expenditures, and the delivery schedule of its automobiles.)

Honest mistakes

Investing Compass
Listen to Morningstar Australia's Investing Compass podcast
Take a deep dive into investing concepts, with practical explanations to help you invest confidently.
Investing Compass

There are, however, more innocent explanations for why Wall Street equity researchers issue so many Buy recommendations. 

One is customer demand. Investors want to hear about what will profit, not what will not. For example, page views on morningstar.com for funds that have a Morningstar Analyst Rating of Gold receive, on average, 120 times as many views as those with the lowest rating of Negative. This partly occurs because Gold funds tend to be larger than Negative funds, and therefore attract greater interest from shareholders. But the bigger reason is reader habits.  

That equity shareholders would rather hear about winners than losers is understandable. So, too, is the attempt of equity analysts to meet investor expectations. Neither party deserves blame. However, the combination of investor demand and analyst response does make for more Buy ratings.

The other factor is psychological. When analysts view their task as identifying buying opportunities, rather than grading on a curve, they will accentuate the positive. They will envision why companies might succeed, as opposed to considering the problems that the firms might encounter. Under such conditions, analyses tend to become narratives, as the researcher tells himself useful stories.

I can attest to this personally. While working as a mutual fund analyst, I realized that my comments were mostly positive. To counteract that tendency, I devised an exercise, forcing myself to place all the funds that were under my watch into three buckets: 1) Above Average, 2) Average, and 3) Below Average. The first group could not be larger than the third group.

The task proved very difficult! I kept finding reasons why a fund was Above Average. This fund had a sterling track record and was sponsored by a leading company; that one had abnormally low costs; a third successfully exploited an unusual investment opportunity. Meanwhile, I had trouble finding funds that struck me as genuinely Below Average. In writing to investors who were seeking funds that they could buy, I was not accustomed to grading on a curve.

In conclusion

My defence of Wall Street equity analysts is impersonal. Morningstar does not qualify as a Wall Street research firm, by this column’s definition (that is, a company that operates an investment bank and/or a brokerage firm). Nor do I have Wall Street analysts as acquaintances. We occupy different worlds.

That said, I don’t think that the standard criticisms of Wall Street research are particularly helpful. Investors should certainly know that equity recommendations are overwhelmingly positive. Buyer beware. However, the underlying causes for this situation go far beyond the usual explanation of “Wall Street sharks.” They are a blend of business pressures, investor expectations, and research habits.

In short, one shouldn’t expect conditions to change. Even in the unlikely event that Main Street companies stop bullying Wall Street firms, there are other reasons why Buy recommendations will outnumber Sells.  Consequently, equity investors should develop the habit of considering the drawbacks of popular stocks. Professional equity analysts have thoroughly evaluated what might go right. They may not, however, have spent enough time on what could go wrong.  

is vice president of research for Morningstar.

© 2022 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'regulated financial advice' under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information, refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Morningstar’s full research reports are the source of any Morningstar Ratings and are available from Morningstar or your adviser. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782. The article is current as at date of publication.

Email To Friend