Analyst ratings give investors a look into the mind of institutional investors
Analyst ratings are one of many tools available for individual investors. Analysts have the time to study a company’s financials. They also have the access to company insiders that allow them to assess the financial health of the company and where it’s likely to be in the coming quarters.
In this article, we’ll help you understand who analysts are and why their ratings are important. We’ll also review their qualifications; define what the ratings mean in general, and how you should use an analyst’s rating to inform your investment decisions.
What Does a Stock Analyst Do and Why is it Important?
An analyst provides in-depth research into a company’s financials. The result is a rating that gives investors a sense of the opportunity that the company’s stock represents.
In forming their stock analysis, analysts will consider multiple factors including scrutinizing a company’s balance sheet to see if their earnings growth (i.e. revenue and profit numbers) met expectations. The balance sheet will also give them an overview of the amount of debt a company is carrying which may affect their credit ratings. Some analysts will take a deeper look at the company’s fundamentals to see if there are other factors that could affect the stock price.
Analysts will also listen to the conference call (or earnings call) that occurs the day the earnings are released. This gives them insight into things such as unexpected surprises or disappointments. They will use this information to write their analysis which takes into account not only what the company reported, but their interpretation of those results.
Analyst recommendations affect stock trading because they are one way for individual and institutional investors to gauge the prevailing sentiment about a stock based on current market conditions as well as specific issues related to a particular industry. For example, the stock of a technology company that is scheduled to launch a new product may receive a buy recommendation while the broader stock market is in a correction. Similarly, if that company’s launch produces disappointing results, the company may find their rating downgraded in the future regardless of the direction of the overall market.
What Ratings do Analysts Give and What Do They Mean?
The three most commonly used ratings that analysts give are buy, hold, and sell. Here’s what each of these ratings mean:
- Buy Rating: This means that the analyst is making a recommendation for investors to buy this stock or security. In some cases, an analyst may go so far as to refer to a particular security as a “strong buy”.
- Sell Rating: This means that the analyst is making a recommendation for investors to sell or liquidate their position in a stock or security. In some cases, an analyst may refer to a particular security as a “strong sell”.
- Hold Rating: This is sometimes referred to as a “Neutral” rating. When an analyst gives this rating, they are not calling for the investor to take a specific buy or sell action; rather they are giving their opinion on the performance of the stock. In this case, they are projecting that the stock will perform in a way that is consistent with the overall performance of the market and/or comparable companies within that sector or with a similar market capitalization.
In addition to those ratings, many analysts have started to add two additional categories:
- Underperform Rating: Like the “hold” rating, this is a rating that refers to the projected performance of the stock. In the case of underperform it means that the stock is projected to perform below the market or sector average. Depending on the analyst words like “moderate sell”, “weak hold”, or “underweight” may be used to mean the same thing.
- Outperform Rating: In contrast to an “underperform” rating, securities that receive an “outperform” are expected to outperform the market or sector average. Once again, depending on the analyst, different terms may be used such as “moderate buy”, “accumulate”, or “overweight”.
What is the Difference Between a Buy-Side or Sell-Side Analyst?
Analysts come in two categories: buy-side analysts and sell-side analysts. The designation of buy-side and sell-side has nothing to do with the ratings they assign but rather from which side of the transaction they are employed.
For example, buy-side analysts may work directly for an asset manager at an investment institution such as a mutual fund company and have positions (i.e. be invested) in the stocks that they analyze. This frequently means that buy-side analysts have a vested interest in the stock they are analyzing.
In many cases, when a buy-side analyst changes their rating of a company, it may indicate a change in the direction of their own buying patterns. For example, a positive rating of buy or “outperform” could indicate they have already purchased that stock. Likewise, a negative rating of sell or “underperform” could indicate that they have already liquidated their position. However, the buy-side analyst has an incentive to give a rating that accurately predicts the trend of the stock. In so doing, they gain credibility and the fund they work for may experience an increase in investment capital.
Sell-side typically work for an institution where stocks are sold (i.e. a transaction-based firm) such as a brokerage firm. The objectivity of sell-side analysts is more frequently called into question because they may have close relationships with companies that they will subsequently assign a “buy” rating.
Prior to the year 2000 and the infamous “tech bubble” that burst with the spectacular collapse of companies like Enron and WorldCom, sell-side analysts worked at companies that engaged in investment banking. It wasn’t uncommon for these analysts to have close relationships with the companies they covered and subsequently to give these companies mostly favorable ratings. However, after investors suffered extraordinary losses from that collapse, the Federal government responded by imposing stricter regulations for how these analysts covered these companies and ensuring they used commonly accepted valuation methods.
How Much Importance Should Investors Give to Analyst Ratings?
Analyst sentiment is one factor that investors can use to predict the future performance of a stock. When several analysts weigh in with an opinion about as stock, it tends to affect the company’s stock price in the direction of the analysts opinions.
Although analyst ratings are not a guarantee of a stock’s future performance, they carry some weight because analysts have access to a company’s management team and, in some cases, have insights that can be difficult for retail investors to access. The best advice for individual investors when looking for guidance from an analyst’s rating is “to thine own self be true”. As an investor, you bring your own intuition to your trading habits. With that in mind, here are a couple of guidelines to consider before acting on an analyst’s rating.
- Avoid the Herd Mentality – It can be tempting to jump on a stock that is soaring or exit stocks that are falling because of the “herd mentality”. However, this can lead us to invest in stocks of companies we don’t really understand, or to abandon a stock we have legitimate belief in. To avoid this, remember make sure you invest in companies that have business models you understand.
- Know Your Own Risk Tolerance – An analyst rating is typically based on conventional wisdom (i.e. they assume an investor understands if a stock has more, or less, volatility than another). As an individual investor, you have to trade stocks that fit your risk tolerance. A small tech company that is being aggressively traded may have a buy rating, but may be too volatile for your comfort level. Likewise, a blue-chip stock that is given a sell rating may be doing so because it’s not growing as fast as an analyst would like. That growth, however, may be well in line with your investment objectives.
- Be Willing to Change Your Perspective – Analyst’s ratings are a snapshot of a stock’s outlook at a given moment. And you have to view that moment in light of where you are today and where you are going, not on where you were. If you’ve been investing for a long time and are now nearing retirement your risk tolerance and objectives have probably changed. So too will your perspective on certain securities. You may still think a stock is a great long-term buy, but your perspective of long-term has changed.
Some Final Thoughts on Analysts’ Ratings
For better or for worse, stock ratings are a part of an investor’s financial education. At their best, these ratings can help provide an investor with a starting point, or helpful shortcut, for their own research. This is what makes an analyst’s rating an art as much as science. Attempting to forecast things like market volatility is an imperfect task to say the least, and it is subject to an analyst’s reasoned, but still subjective opinions. This can lead many investors to be suspicious of analyst ratings out of concern that they may be biased because the analyst has a financial interest in providing a buy or sell recommendation.
The most important thing for investors to understand about an analyst’s rating is that it may or may not be right for their investment goals or risk tolerance. A buy recommendation for a highly aggressive growth stock does not mean that it is an appropriate stock for a risk-averse investor to buy. Likewise an underweight or sell rating on a stock may simply mean it’s not forecast to grow as fast when compared to other stocks in its industry or with a similar market capitalization. It may however, be perfectly appropriate for an investor who is more interested in capturing a dividend yield.