Stock Ratings: The Good, The Bad And The Ugly

By Rick Wayman AAA

Investors have a love-hate relationship with stock ratings. On the one hand, stock ratings are loved because they succinctly convey how an analyst feels about a stock. On the other hand, they are hated because they can often be a manipulative sales tool. This article will look at the good, the bad and the ugly sides of stock ratings.

The Good: Soundbites Wanted
Today's media, and investors, demand information in soundbites because our collective attention span is measured in nanoseconds. "Buy", "sell" and "hold" ratings are effective because they quickly convey the bottom line to investors.

But the main reason why ratings are good is that they are the result of the reasoned and objective analysis of experienced professionals. It takes a lot of time and effort to analyze a company and to develop and maintain an earnings forecast. And, while different analysts may arrive at different conclusions, their ratings are efficient in summarizing their efforts. However, a rating is one person's perspective, and it will not apply to every investor. (For more insight, see Earnings Forecasts: A Primer.)

The Bad: One Size Does Not Fit All
While each rating succinctly conveys a recommendation, this rating is really a point on an investment spectrum. It is like a rainbow, in which there are many shades between the primary colors.

A stock's investment risk and an investor's risk tolerance cause the blurring between the primary recommendations. A color may be a specific point on the spectrum, but the color's specific electromagnetic arrangement can be perceived differently by different people, either because of individual characteristics (like color blindness) or perspective (like looking at the rainbow from a different direction), or both.

A stock, unlike the fixed nature of the electromagnetic spectrum (a color's place along the spectrum is fixed by physics), can move along the investment spectrum and be viewed differently by different investors. This "morphing" is the result of individual preferences (individual risk tolerance), the business risk of the company and the overall market risk, which all change over time.

The Stock Rating Spectrum
For example, think of a line (or rainbow) and imagine "buy", "hold" and "sell" as points at the left end, middle and right end of the line/rainbow. Now let's examine how things change by examining the history of AT&T (NYSE:T) shares.

First, let's examine how perspectives at one point in time matter. In the beginning (say, in the 1930s), AT&T was considered a "widow-and-orphan" stock, meaning it was a suitable investment for very risk-averse investors: the company was perceived as having little business risk because it had a product everybody needed (it was a monopoly), and it paid a dividend (income that was needed by the "widows to feed the orphans"). Consequently, AT&T stock was perceived as a safe investment, even if the risk of the overall market changed (due to depressions, recessions or war).

At the same time, a more risk-tolerant investor would have viewed AT&T as a "hold" or "sell" because, compared to other more aggressive investments, it did not offer enough potential return. The more risk-tolerant investor wants rapid capital growth, not dividend income: risk-tolerant investors feel that the potential additional return justifies the added risk (of losing capital). An older investor may agree that the riskier investment may yield a better return, but he or she does not want to make the aggressive investment (is more risk-averse) because, as an older investor, he or she cannot afford the potential loss of capital (needs the dividend income to "feed the orphans"). (For related reading, see Personalizing Risk Tolerance.)

Now let's look at how time changes everything. A company's risk profile ("specific risk" in Street talk) changes over time as the result of internal changes (e.g.. management turnover, changing product lines, etc.), external changes (e.g.. "market risk" caused by increased competition), or both. AT&T's specific risk changed while its break-up limited its product line to long-distance services, and while competition increased and regulations changed. And its specific risk changed even more dramatically during the dotcom boom in the 1990s: it became a "tech" stock and acquired a cable company. AT&T was no longer your "father's phone company," nor was it a "widows and orphans stock." In fact, at this point the tables turned. The conservative investor who would have bought AT&T in the 1940s probably considered it a "sell" in the late 1990s. And the more risk-tolerant investor who would not have bought AT&T in the 1940s most likely rated the stock a "buy" in the 1990s.

It is also important to understand how individuals' risk preferences changes over time and how this change is reflected in their portfolios. As investors age, their risk tolerance changes. Young investors (in their 20s) can invest in riskier stocks because they have more time to make up for any losses in their portfolio and still have many years of future employment (and because the young tend to be more adventurous). This is called the "life cycle theory of investing". It also explains why the older investor, despite agreeing that the riskier investment may offer a better return, cannot afford to risk his or her savings.

In 1985, for example, people in their mid-30s invested in startups like AOL because these companies were the "new" new thing. And if the bets failed, these investors still had many (about 30) years of employment ahead of them to generate income from salary and other investments. Now, almost 20 years later, those same investors cannot afford to place the same "bets" they placed when they were younger. They are nearer to the end of their workable years (10 years from retirement) and thus have less time to make up for any bad investments.

The Ugly: Ratings Are Being Used as a Substitute for Thinking
While the dilemma surrounding Wall Street ratings has been around since the first trade under the buttonwood tree on Manhattan Island, things haven turned ugly with the revelation that some ratings do not reflect the true feelings of analysts. Investors are always shocked to find such illicit happenings could be occurring on Wall Street. But ratings, like stock prices, can be manipulated by unscrupulous people, and have been throughout time. The only difference is that this time it happened to us.

But just because a few analysts have been dishonest does not mean that all analysts are liars. Their assumptions may turn out to be wrong, but this does not mean that they did not do their best to provide investors with thorough and independent analysis.

Investors must remember two things. First, most analysts do their best to find good investments, so ratings are, for the most part, useful. Second, legitimate ratings are valuable pieces of information that investors should consider, but they should not be the only tool in the investment decision-making process. (To learn about how an analyst makes his or her career, see Sizing Up A Career As A Ratings Analyst.)

The Bottom Line
A rating is one person's view based upon his or her perspective, risk tolerance and current view of the market. This perspective may not be the same as yours. The bottom line is that ratings are valuable pieces of information for investors, but they must be used with care and in combination with other information and analysis in order to make good investment decisions.

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