I am a new investor. Yesterday I saw that Legato Systems (LGTOE) was upgraded to a "buy." So I was anxious to get into it. The price was at $13.63. I thought the company would be fine. However, after I read your recent article, I am wondering whether I should keep it or sell it right away. -- Janet Wong
Before opening a brokerage account, every investor should be given a lexicon to decipher Wall Street analyst recommendations.
In Street parlance, a hold rating is a message to sell. Actual sell ratings barely exist.
Sell-side analysts rarely -- if ever -- come out and tell investors to unload a stock. However, you can learn to interpret these carefully worded recommendations and occasionally glean some useful information from this ratings game.
"Analyst recommendations, and what they say, give you direction. You have to make a judgment on your own as what that direction really means," says Jack Rivkin, executive vice president of
and former head of research at
Most brokerage firms use a five-point ratings scale to label analyst ratings. A strong buy is the best recommendation, which is assigned a one. Then comes just a buy, which gets a two. A neutral rating is a three. A sell and a strong sell are the lowest ratings and are assigned a four and a five, respectively.
The wording of these designations can vary slightly from firm to firm. At
, the ratings run from buy, accumulate and neutral to reduce and sell -- covering the numerical scale from one to five. Instead of accumulate,
uses the word outperform. Reduce is called underperform.
That verbiage isn't difficult to interpret, but you still have to learn to read between the lines. You must know when to discount positive ratings. And since outright negative ratings are rare, you must learn the other ways analysts have of sending negative signals.
Of the roughly 5,000 stocks and 28,000 current ratings tracked by
First Call/Thomson Financial
, fewer than 1% are sell ratings.
One-third of the ratings are strong buys. Another third are buys and one-third are holds, says Joe Cooper, a First Call research analyst. The remaining two categories -- sell and strong sell -- command a minuscule 0.8% of the total. (During the 1990s, that distribution has been about the same.)
The reasons take longer to explain.
For one, analysts choose the companies they cover.
"Analysts aren't going to invest time and effort if they don't feel over a long period of time that, on balance, they can recommend a stock," says Rivkin.
More importantly, numerous conflicts are embedded in the investment banking business itself.
A sell rating that sends a stock plunging will certainly irritate a company, and an angry company might just pull its lucrative investment banking business from a firm whose analyst is negative about the stock.
Two, a company, if provoked, can and will cut off an analyst from the flow of information and deny that analyst any access to the company's executives.
Someone who has been cut off by a company will surely have a hard time analyzing it. An analyst's job includes producing research reports, price targets and earnings estimates. Talking to a company's management about its growth, direction and overall financial health is an integral part of the job. Without that contact, an analyst's coverage could suffer, especially when compared to that of other analysts following the same company.
While covering banks at
Donaldson, Lufkin & Jenrette
, former sell-side analyst Tom Brown was critical of
, and the bank retaliated by barring Brown from visiting the company's headquarters in Charlotte, N.C. a few years ago.
In the early 1990s, analyst Marvin Roffman was actually fired by
Janney Montgomery Scott
after making negative comments about the
casino in Atlantic City, which angered owner Donald Trump.
"I don't know if the average investor would benefit from looking at the ratings systems," admits Brown, who now runs his own money management and research firm called
Second Curve Capital
in New York. "If you give a sell, the people it truly affects are the people who own the stock. It says, 'No offense Mister, but you're an idiot for owning the stock.' "
So analysts play this game using code words.
"A system is in place that allows analysts to change their relative view without offending the company," says Rivkin.
For individual investors, cracking this code is key.
You can't take a buy or a strong buy at face value. An analyst may upgrade a stock's short-term rating because he or she thinks a small piece of news might give the stock a pop. "An analyst is afraid there will be a near-term upward movement and doesn't want to look foolish," says Brown.
On the negative side, an analyst's short-term downgrade might simply be a result of valuation. A stock's price may have gotten ahead of itself, as they say. For long-term owners of a stock, this move might be irrelevant.
On the other hand, a downgrade could reflect a change in the analyst's outlook for the company. A downgrade from a buy rating to a neutral could be a message that something fundamental has changed with a company.
Rivkin gives the following example: "If an analyst has a strong buy on a stock and comes out with a report cutting earnings estimates and moves from a strong buy to a buy, that is a signal. That is new information."
You need to know the history of an analyst and the history of analysts with that particular company. If an analyst has been a long-time bull on a stock and suddenly downgrades it, that move might be an indication that something is awry.
A very good analyst with a big following among institutional and retail investors can move a stock.
On April 24, powerful
analyst Rick Sherlund removed
from the firm's recommended list and downgraded it to market outperform from buy after the company reported lifeless results for the quarter and warned that profit growth will slow in the next fiscal year.
That downgrade was widely believed to be the trigger for the stock's 15% drop that day.
But all too often, Wall Street analysts are more reactive than proactive. In the case of
Procter & Gamble
earlier this year, many analysts covering the consumer-products giant
failed to see any of the warning signs leading up to the company's announcement of an earnings shortfall. The oversight suggests analyst ratings are assembled mostly from a company's guidance rather than from actual fundamental analysis.
On Jan. 20, seven of 14 analysts covering Legato downgraded the stock from a strong buy or buy to hold, according to First Call. But those downgrades occurred the day
the Palo Alto, Calif.-based developer of data backup and recovery software announced it had failed to meet fourth-quarter earnings projections and was changing its accounting practices.
Those downgrades would have been more useful if they had foreshadowed the company's shortfall. Then again, the stock has fallen another 57.4% since Jan. 20 and closed Tuesday at 12 11/16.
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