Stock Ratings That Won't Give You the Runaround

Which service should you follow? Depends on your style

Investors looking for objective advice from Wall Street analysts might as well be searching for Big Foot or Jimmy Hoffa's body. As the bear market has made clear, analysts are often just puppets of their firm's investment banking arm. They almost never say sell on a stock lest they anger a client or potential client. Just consider this: With the economy on the brink of recession, only 1.5% of U.S. stocks have analyst "sell" ratings, according to First Call, a stock research firm. Nearly 65% are still "buys," and 34% are rated "hold."

So where do you get advice that's free of investment-banking connections? It's available on newsstands that sell Investor's Business Daily, in the mailbox if you are a Value Line Investment Survey subscriber, and online at such sites as morningstar.com and our own businessweek.com, which carries Standard & Poor's stock reports. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies.) Except for Morningstar, which just launched its ratings system, all have long track records. Recommendations at Value Line, the oldest of the stock ratings firms, have delivered a 19.1% annualized return over the past 36 years, besting the S&P 500-stock index's 11.4%.

Each ratings service takes a different approach. Depending on market conditions and your personal investment style, you might prefer using one instead of another (table, page 114). Stocks that get high marks in the Value Line and Investor's Business Daily systems are usually those with a lot of momentum, both in earnings growth and stock price appreciation. IBD ranks stocks from 1 to 99, with 99 the highest. Value Line uses a 1-to-5 system in which a 1 is the most desirable rating.

Morningstar takes a more traditional valuation approach, giving the highest ratings to companies selling at a sizable discount to the value of expected cash flows. A five-star stock is a "strong buy," one star a "strong sell." Standard & Poor's offers two sets of ratings. One, like IBD's and Value Line's, is quantitative and evaluates stocks relative to their fair value on a 1-to-5 scale, with 5 the best. S&P's other ratings system uses one to five stars, with five as the best. S&P Star ratings are based on an analyst's opinion of the stock.

DIFFERENT TAKES. To see how varied the ratings can be, take a look at eBay (EBAY ), one of the few profitable e-commerce stocks. Morningstar gives eBay only one star. How come? Morningstar Internet analyst David Kathman estimated eBay's annual revenues to come up with an earnings growth projection of 69% through 2005. He also figured in the company's asset turnover, or how efficiently it uses its assets. Plugging these numbers into a discounted cash-flow model, he arrived at a fair value for the stock of $40. Since eBay trades at $55, the company is now 38% overvalued. At Morningstar, anything more than 30% overvalued automatically receives one star; more than 30% undervalued, five.

Value Line has a very different take. It gives eBay a 1 for its Timeliness rating. That means it's one of 100 stocks that Value Line expects to outperform the lower-ranked stocks in its 1,700-stock universe. The reasons? First, eBay's earnings have more than quadrupled, to 9 cents a share in 2001's second quarter from 2 cents a share in the same quarter last year. In market performance, it's outpacing most of the other stocks Value Line covers and beating its Value Line analyst's earnings estimates.

IBD also lauds eBay. Under the IBD's SmartSelect Composite Rating system, eBay ranks high for earnings growth, sales, profit margins, and return on equity, and it does fairly well on stock price performance. The trading-volume indicator is neutral, neither a positive nor negative for the stock. All told, the composite score was 92 out of a possible 99. Anything over 80 is considered a buy--if the market is favorable for buying. (In its column called "The Big Picture," IBD rates the stock market as a whole, and right now its model is saying cash is better than stocks.)

Standard & Poor's is of two minds on eBay. Under the purely quantitative Fair Value system, the company gets a 1, the lowest rating--it's just pricey relative to its prospects. Under the star ratings, it gets four of them, which means investors should "accumulate" stock--i.e., buy, but take your time doing it. Why the stark difference in recommendations? Says Scott Kessler, S&P's Internet analyst: "eBay is one of the few companies in the Internet sector to thrive in a dot-com downturn. It deserves a premium valuation."

Both approaches are noteworthy. S&P says stocks that got a 5 on its quantitative system have beaten the S&P 500 in 9 of the past 14 years. And the analyst-chosen five-star stocks have beaten the S&P 500 index in 10 of the past 14 years. Another useful S&P stat in the quant section is the Earnings & Dividend Rank, which rates stocks from A+ to D on their earnings growth and stability over the past 10 years. In the past 14 years, high-earning A+ stocks performed best in bear markets, while C and D stocks were stronger in bull markets.

So which ratings system should you follow? It depends on your instincts. A savvy analyst may have insights that a rating generated purely from crunching numbers will simply not find. On the other hand, numbers are completely objective. "Our ratings are not based on our opinion or Wall Street's opinion but on investment models that have worked in every market cycle," says IBD founder William O'Neil.

Of course, even black-box models have some subjectivity, since someone has to construct programs that crunch the numbers (page 120). And some models blend all sorts of analyses. Morningstar's final rating is determined by a quantitative model, but the earnings estimate is made by an analyst. If Kathman incorrectly assessed eBay's growth potential, that skews its Morningstar rating favorably or unfavorably. The same holds true at Value Line, though estimates are much less significant to its model.

Although these ratings firms have no investment-banking ties, potential conflicts exist. At Morningstar, analysts are allowed to own stocks they cover. That could make them overly bullish about a favorite company. Standard & Poor's changed its ownership policy three years ago, forbidding analysts from buying their covered stocks, but they can hold onto existing positions. S&P's biggest business is not rating stocks but rating bonds for issuers, which could present a conflict, too. But S&P says it keeps stock and bond analysts strictly separated because companies give the bond analysts private information they need to perform their work.

BIG RETURN. While objective advice is important, you should also consider each ratings services' trading habits. If you're a long-term investor who doesn't like checking stock prices every hour, you're better off with Morningstar. It expects its top-rated stocks to reach their target prices in three to five years. S&P's star-ratings outlook is shorter, only six to 12 months. Value Line reruns its Timeliness ratings every week, and IBD every day, so recommendations from those two services have shorter life spans.

Admittedly, IBD's momentum-driven style has produced some spectacular returns. According to IBD's O'Neil, his buy lists generated a 48,133% cumulative return from 1977 (the newspaper didn't start publishing until 1984) through the end of 2000. That compares with a 2,863% return in the S&P 500. Yet O'Neil's calculations are not from an actual portfolio, and they exclude trading costs and taxes.

Breadth of coverage also should be a consideration. By sticking to its purely quantitative approach, IBD can rate more stocks--currently over 10,000, or 80% of the entire U.S. stock market. By contrast, Morningstar's 25 analysts only cover 500 stocks; S&P's 35 equity analysts, 1,070; Value Line's 70 analysts, 1,700. What gets left out are mainly the smallest companies, some of which may offer excellent opportunities.

Depending on your preference, you can access all of these ratings in paper reports or online. Online is more up-to-date, however, which is important if you're using Value Line or IBD's momentum systems. A $197 annual subscription to IBD gets you the daily paper and access to its site, investors.com. Value Line charges $570 for one year of the weekly publications and an additional $145 for online access. Morningstar's online subscription is $99 a year.

You can buy S&P reports at www.businessweek.com for $5 each, and magazine and Web site subscribers can get three free reports a month. The site's Portfolio Tracker--free to those who register at the site--also gives you S&P Star and Fair Value ratings, but without the complete analyst reports. Or you could subscribe to the Stock Reports section of S&P's Advisorinsight.com for $995 a year. This allows you to screen for top-rated S&P stocks and view as many reports as you like.

No rating can perfectly capture the essence of a company or explain why you should or shouldn't invest in it. But any way you look at it, these ratings services provide more objective analyses than anything you would get from the Street.

By Lewis Braham

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