Heard on the Street: Analysts Flunk on Risk Meter, Stock-Performance Study Says
By KEN BROWN
Staff Reporter of THE WALL STREET JOURNAL
Investors have gotten a harsh lesson about risk in the stock market over the past couple of years. But Wall Street analysts -- those professional stock-pickers who should know all about the subject -- appear to have played hooky the day it was taught in business school.
A study of analysts' picks over the past three years shows that the stocks they rated "buy" or "strong buy" had far more risk than the average stock in the market and only marginally higher returns.
Not only should investors have avoided the stocks that Wall Street was touting, the study said, but also they should have actually bought the stocks on which the analysts were lukewarm. According to the study, conducted by Risk Metrics Group, a firm that specializes in risk measurement and management, the average return on the stocks that the analysts rated as holds was greater than the buys and strong buys. The holds also turned out to be less risky.
Picking risky stocks can be a good investment strategy, as long as there is a bull market. So, not surprisingly, the analysts' picks did quite well for a while. But after the stock market began crumbling in March 2000, those risky stocks did just what risky stocks do in a downturn. They went to pieces.
"It's not in the nature of the people in the business to talk about risk if they can help it," says Peter L. Bernstein, the author of "Against the Gods: The Remarkable Story of Risk."
"And it's certainly not in the nature of individuals, uninitiated investors, to think about it, but it's enormously important," he adds.
The study helps explain why Wall Street analysts looked so prescient as stock markets soared in the late 1990s. And it shows why so many of them have been so wrong since then.
To do the study, Risk Metrics, an independent company that was spun out of J.P. Morgan three years ago and has many of the world's central banks as its clients, looked at nearly 89,000 stock recommendations from seven big Wall Street firms going back to September 1998. The recommendations were culled from the brokers' monthly lists of their stock ratings. The firm divided the recommendations into strong buy, buy and hold. Then it ranked the stocks based on its own statistical measure of volatility, called a RiskGrade, on a scale of 1 to 1,000, 1 being no risk. Finally, it looked at the returns for the 12 months after the recommendation was made.
The results show that most Wall Street analysts gave their highest ratings to risky stocks, stocks that would most likely go up more than the average stock during a bull market and down more during a bear market.
The average RiskGrade for stocks with Wall Street's highest rating, the ones it rates strong buy, was 292. The RiskGrade for Wall Street's second-favorite stocks, the ones it rates buy, was lower, at 283, and the RiskGrade for its holds was 271. By comparison, the average stock in the Standard & Poor's 500-stock index had a RiskGrade of 232. And since adding stocks to a portfolio generally lowers risk, the RiskGrade for an index fund that tracks the S&P 500 is just 86.
But the returns for the analysts' top picks find that investors got no benefit for taking on that additional risk. The highest rated stocks, the strong buys, returned 12.5%, the buys returned 12.1% and the holds returned 12.8%. In other words, investors who bought the holds got slightly better performance with less risk.
Risk worked in the analysts' favor during the tech-stock rally. For example, the stocks that got the highest ratings in March 1999 soared 66.8% over the next year. But once the bubble popped, risk reared its head. The stocks with the highest recommendations in September 2000 lost 16.7% through June, the last month for which data are available. The holds gained 8.6% in that period.
Credit Suisse Group's Credit Suisse First Boston, which underwrote the initial public offerings of many hot technology stocks, had the riskiest group of strong-buy recommendations, followed by Bear Stearns, J.P. Morgan Chase, Citigroup's Salomon Smith Barney and Goldman Sachs Group, with Merrill Lynch and Morgan Stanley tied for the least risky. But CSFB's top picks performed far better than its rivals', returning 31.8% in the 12 months after the recommendation, compared with the 12.5% average 12-month return for the top picks of the seven firms.
John Hoffmann, director of global equity research at Salomon Smith Barney, says many firms require analysts to look for stocks with potential upsides of 20% or more for strong-buy ratings, which is part of the reason analysts gravitate to more risky stocks.
To Mr. Hoffmann, this argues for analysts putting risk ratings on stocks along with their buy or sell recommendations. "If you don't have that discipline, you can see why analysts will get in trouble, because they are always going to swing for the fences," he says.
Salomon Smith Barney issues risk ratings for all the stocks it recommends, as does Merrill Lynch. In April, Morgan Stanley started putting a risk label on the most volatile stocks it covers, and right now 27% of the stocks the firm rates strong buy or buy are carrying the label. The other four firms in the Risk Metrics study don't use risk ratings, though their analysts discuss risks in their stock reports.
At Salomon Smith Barney, stocks get four risk ratings -- low, medium, high and speculative -- and Mr. Hoffmann says stocks with low or medium risk can be strong buys, even if they are expected to return as little as 15% over the next year or so.
That said, Salomon Smith Barney analysts recommend few low-risk stocks. Of the 404 stocks with the Salomon Smith Barney's firm's top recommendation, just 14 are considered low risk and 128 get a medium rating.
Andy Melnick, director of global research at Merrill -- which has received criticism for touting risky Internet stocks -- notes that nearly all of Merrill's tech stock picks carried high-risk ratings.
But he adds: "The system broke down broadly, not just here. People got greedy, that's the bottom line."
Write to Ken Brown at ken.brown@wsj.com1
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