Merrill Increases Sell Recommendation Quota


New York – An article in the New York Times this morning discusses the new mandate for Merrill analysts to have certain percentages of their coverage in the “buy”, “neutral” and “underperform” camps. Of course, one of the criticisms of Wall Street Analysts has been their tendency to be overly optimistic about the stock market the large number of buys relative to sells in their portfolio of recommendations.

At present, about 12% of Merrill’s recommendations are negative. According to Bloomberg, this compares to the average of sell side negative recommendations of about 5%. And even this is up from the 2% sell recommendation proportion of the dotcom era.

To establish reasonable guidelines for analysts, Merrill looked at the previous 10 years of stock movements and found that somewhere close to 40% of the stocks on the S&P 500 and the MSCI World Index declined in a given year.

Merrill’s rules say that analysts cannot have more than 70% of their recommendations as buys, cannot have more that 30% of their stock picks as neutrals, and cannot have less than 20% of their stocks in the underperform category.

Not to undermine what Merrill is trying to accomplish with this quota system, but there are a few concerns we have with this system. First, is the use of the average year as a guideline for any particular year. It may be entirely appropriate to issue a much larger that 70% buy ratings in some very strong years. If this is the case, then the analyst must allocate neutrals or underperforms that he/she does not believe in. Second, the analysts must have some form of criteria for doing a complete ordering of their portfolios. Will each analyst need to become more mechanistic and utilize quantitative systems to rank stocks?

The third point is more of a question than a concern. The article points out that the number of analysts at Merrill is now 750, down from 900 in 1999. Yet, Merrill is covering more stocks than it was in 1999. Even so, the number of stocks covered per analyst averages 5, which is a very respectable ratio. One way for an analyst to adhere to the quota system is to have 1 underperform (20%), 1 neutral (20%) and 3 buy (60%) recommendations through out the year. The other extreme would be to have all stocks as buys buy only for 7/10ths of the year—you get the idea. The most likely scenario will be for the analysts to increase–either deliberately or subconsciously—the turnover rate of their recommendations to make the rules less of a constraint on decision making.

The folks at Merrill are very bright, so we are absolutely certain all of our above concerns have been already aired and overruled. So what is the motivation for this move? The most obvious rationale might be to position Merrill as a leader in addressing the recommendation bias on Wall Street. Another potential benefit is the likely impact on recommendation turnover. If the rules do actually increase the turnover in recommendations, the research product would become more interesting to the hedge fund community. And given that NYT reports that hedge funds are doing as much as 75% of the volume in some markets, appealing to them would seem to be an important strategic initiative for Merrill and the sell-side in general.


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