Investment Research: Ignore the Ratings, Read the Reports

As the New York State attorney general at the time, Eliot Spitzer (now governor of New York) worked in concert with the SEC to legally strong-arm the brokers/investment banks, threatening to close them down unless changes were made in the way brokerages conducted their business. As a result, a comprehensive agreement was made between the regulators and the industry, which net civil penalties and important reforms.

These reforms included:

• Enactment of "Regulation AC," which is highlighted by definitions of industry terms such as "research analyst" and "research report," a requirment that analysts certify all research reports, and disclosure for certain analyst compensation arrangements.
• Disclosure of holdings on behalf of the analyst and his or her relatives as well as any other conflicts of interest.
• Strengthening the "Chinese Wall."
• Disclosure of the rating system and pertinent statistics for the analyst's employer.

It is the rating system disclosure that I believe fell short of accomplishing meaningful reform, as it tends to cause a great deal of frustration and confusion on the part of investors.

Ratings: Think Golf

Each research company has its own rating system. Some have simple ratings like "buy," "sell" and "hold." Others use terms like "accumulate," "overweight" and "underweight." What these ratings mean is subject to great variability and subjectivity. There is no industry standard or objective measure.

So here is how I look at ratings and how I teach my students to view them.

In golf, you gauge your performance based on par, which is the amount of strokes that an average golfer is expected to need to complete a round of golf. For stocks, the "par" is an expected return . You can either look at the historical expected return of a broad-based index or the expected return for the next year. Then if your stock is expected to increase by, let's say, 2% of the market's expected return, that stock should be a "hold." If the stock is expected to do better, it's a "buy," and if performance expectations are extremely high, then it's a "strong buy."