What Analyst Ratings Really Mean

In-the-know people on Wall Street know that an analyst's "buy" or "sell" rating on a stock has many shades of subtlety. But do ordinary investors understand the code?

Stephen McClellan thinks not, and he should know. He issued more than a few of these ratings himself during a 32-year career as a technology industry analyst for Merrill Lynch and Salomon Brothers.

In his new book,Full of Bull: Do What Wall Street Does, Not What it Says, to Make Money in the Market(FT Press), McClellan says most top analysts spend about 15% of their time on actual research. They spend the rest of their time, McClellan says, on marketing activities intended to enhance their standing and build business for their employers.

He counsels investors to use Wall Street research as industry background material and to ignore buy and sell calls, price targets and earnings estimates. That's how the pros use it, he says. Over breakfast in New York recently, we asked him for more of his insider's view of how the Street really works.

KIPLINGER'S: What, if anything, is different today as a result of Wall Street's 2003 legal settlement with the Securities and Exchange Commission that was supposed to cleanse research of its many conflicts of interest?

MCCLELLAN: It used to be the analyst would talk to investment bankers on a daily basis and help bankers bring in deals. Their research was very much influenced by whether they could do a big banking deal and so on. In other words, they worked together. It was a team effort.

That direct, heavy-handed investment banking leverage and influence over analysts has very much dissipated. Now it's very, very arms length.

However, Wall Street analysts know about every stock they cover whether their firm has an investment banking relationship and does investment-banking business. They can't help but not know that. Therefore, it still is a subtle influence in terms of a positive rating on a stock. If you're very negative on a stock, that would result in a neutral rating. It would certainly never be a sell rating because you don't want to upset the management.

Fill us in a little bit more on how to interpret "buy" and "sell" calls.

It's hilarious. You need a codebook to decode it. When a stock goes from one of those very rare sell ratings up to a neutral, that is a strong buy. When a rating is lowered from a buy to a neutral or a hold, that's a very strong sell.

Obviously, there's a reticence to ever use the big, bad s-word. There are two big audiences who object vociferously to that, and they're the biggest audiences that the brokerage firm has. They're big institutional investors like mutual funds, and they're corporate executives, which is where all the banking business comes from. In fact, only 5% of all the ratings on Wall Street are sells right now in this bear market.

Then, there's the Toll Brothers example, which is in the book. A big brokerage firm had an outperform rating on Toll when its price was $29, but the price target was $23. Well, what they were trying to say was, the stock will go down six points all right, but it won't go down as much as rest of the homebuilding stocks, which is hilarious. In that case, an outperform meant sell!