The Day Ahead: Simplify Wall Street's rating system

How to find your way through Wall Street's incomprehensible and often nonsensical ratings system
Written by Larry Dignan, Contributor

Merrill Lynch's Henry Blodget has quite a reputation for talking out of both sides of his mouth and being bullish about Net stocks even as he's downgrading them. When Blodget "reset his sector ratings" last week, it gave the media and Wall Street critics just another round of ammunition.

But you can't completely blame Blodget -- he's just a product of a Wall Street stock rating system that could easily be confused with psychobabble.

Although it's perfectly logical to wonder about Blodget's timing (he just noticed business-to-consumer stocks stink), the bigger picture is being missed. Blodget and many other analysts are allowed to cover their tails on nearly every stock call because of complex, if not confounding, rating systems. What exactly is the difference between a weak buy and a strong buy?

In real life there are three options. You buy a stock. You hold a stock. Or you sell it. Simplify Wall Street's ratings to "buy", "hold", and "sell", restore the meaning in these rankings and everyone will be more accountable. The best you'll find on Wall Street is a five-tier rating system.

Armed with Merrill's complicated stock rating system, Blodget can get away comments such as this: "We are resetting the investment ratings for our Internet universe," he wrote in a research note. "The purpose of the reset is not to make a new 'call' on the direction of the group but to provide a more precise differentiation of our current opinions."

With that statement setting the stage, Blodget went on to downgrade eToys to a D-3-2-9 from a D-2-1-9, Barnesandnoble.com to a D-3-1-9 from a D-2-1-9 and Pets.com to D-2-2-9 from a D-1-1-9. He left the ratings for Yahoo!, Amazon.com and America Online untouched.

When Blodget was done downgrading 11 Internet stocks, investors were left unamused and confused. For the record, Merrill gives a letter risk rating (D is the riskiest), an intermediate term rating (1 is a buy, 3 is a neutral and 6 is a sell), and a long-term rating (more than 12 months). The numeral 9 indicates there are no cash dividends.

Roughly translated, Blodget gave eToys a "weak hold", Pets.com a "weak buy", and Barnesandnoble.com a "hold". Translation: you should have bailed on these stocks months ago. Does Pets.com's weak buy mean you should still buy it, but keep your enthusiasm to a minimum?

Now contrast these goofy ratings to what happens in real life. Just try calling your broker and saying, "I'd like to 'weak buy' that stock". Wall Street has created a world where "neutral" and "hold" mean it's time to sell. "Can you neutral that stock and send the cheque to me?"

If you listened to analysts, you'd never sell anything. Those optimistic analysts rarely do sell ratings. According to First Call, less than one percent of analysts actually hand out sell ratings.

Thomas O'Keefe, a research analyst with First Call, said most firms have a 1-through-5 grading scale with 1 being a strong buy and 5 a sell. "They want to provide a ranking scale," said O'Keefe. "But in the long term you can only do three things: buy, hold or sell."

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