More Sell Recommendations at Merrill
New York – An article in the New York Times this morning discusses
the new mandate for Merrill analysts to have certain percentages of their
coverage in the “buy”, “neutral” and “underperform” camps. Of course, one of the criticisms of Wall
Street Analysts has been their tendency to be overly optimistic about the stock
market the large number of buys relative to sells in their portfolio of
recommendations.
At present, about 12% of Merrill’s recommendations are
negative. According to Bloomberg, this compares to the average of sell side negative
recommendations of about 5%. And even this is up from the 2% sell
recommendation proportion of the dotcom era.
To establish reasonable guidelines for analysts, Merrill
looked at the previous 10 years of stock movements and found that somewhere
close to 40% of the stocks on the S&P 500 and the MSCI World Index declined
in a given year.
Merrill’s rules say that analysts cannot have more than 70%
of their recommendations as buys, cannot have more that 30% of their stock
picks as neutrals, and cannot have less than 20% of their stocks in the
underperform category.
Not to undermine what Merrill is trying to accomplish with
this quota system, but there are a few concerns we have with this system.
First, is the use of the average year as a guideline for any particular year.
It may be entirely appropriate to issue a much larger that 70% buy ratings in
some very strong years. If this is the
case, then the analyst must allocate neutrals or underperforms that he/she does
not believe in. Second, the analysts must have some form of criteria for doing
a complete ordering of their portfolios.
Will each analyst need to become more mechanistic and utilize
quantitative systems to rank stocks?
The third point is more of a question than a concern. The
article points out that the number of analysts at Merrill is now 750, down from
900 in 1999. Yet, Merrill is covering more stocks than it was in 1999. Even so,
the number of stocks covered per analyst averages 5, which is a very respectable
ratio. One way for an analyst to adhere to the quota system is to have 1
underperform (20%), 1 neutral (20%) and 3 buy (60%) recommendations through out
the year. The other extreme would be to
have all stocks as buys buy only for 7/10ths of the year—you get the idea. The
most likely scenario will be for the analysts to increase--either deliberately
or subconsciously—the turnover rate of their recommendations to make the rules
less of a constraint on decision making.
The folks at Merrill are very bright, so we are absolutely
certain all of our above concerns have been already aired and overruled. So
what is the motivation for this move? The most obvious rationale might be to
position Merrill as a leader in addressing the recommendation bias on Wall
Street. Another potential benefit is the likely impact on recommendation
turnover. If the rules do actually increase the turnover in recommendations,
the research product would become more interesting to the hedge fund community.
And given that NYT reports that hedge
funds are doing as much as 75% of the volume in some markets, appealing to them
would seem to be an important strategic initiative for Merrill and the sell-side
in general.
