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How to Trade Using Analysts Ratings

Posted on Tuesday, January 8th, 2019 by MarketBeat Staff

Summary - 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. A stock rating is the result of many hours of detailed research. When analysts provide their recommendations, they have taken the time to look at a company’s balance sheet to come up with an earnings forecast that takes into account the financial health of the company at that moment, but also where it is expected to move in the subsequent quarter.

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.

And to further muddy the waters, there can be other categories of ratings beyond the traditional buy, sell, or hold. This can make it difficult for investors to get an accurate picture. However because most analysts deliver their ratings at the same time, investors can view not only what an individual analyst thinks about a stock, but what the consensus opinion is of a particular stock. This can serve as an effective way of noticing outlying sentiment, which may give investors a clue to the analyst’s point of view.

But the most important thing for investors to understand 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 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 similar market capitalization. It may, however, be perfectly appropriate for an investor who is more interested in capturing a dividend yield.

Introduction

Analysts actively evaluate companies and deliver reports on a regular basis. However, with the advent of round-the-clock financial news, the opinion of an analyst can set a stock soaring or crashing in a matter of days, or even hours. In fact, the increased media exposure has also given a name and a face to these analysts. And while many analysts share many credentials, they are not the same, which can affect the way they rate individual stocks.

This is why one analyst can see the stock as a buy and a different analyst can view it as “overweight” or even a “sell”. It’s also a reason investors can wonder how some stocks can beat the expectations that are set. What methodology is being used?

This article will 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 trading decisions.

What does an analyst do?

Essentially, the job of an analyst is to do the legwork for investors. It doesn’t mean that investors shouldn’t perform their own due diligence to form their own opinion, but it means that they can take care of ensuring investors have the data they need. They do this by estimating what earnings they think will be reported. Companies provide limited guidance so they will typically use their own computer models, valuation calculations, and factor in current economic conditions. They 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 take this information to write their analysis which will take into account not only what the company reported, but their interpretation of those results.

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.

Why are analyst ratings important?

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 are the qualifications of an analyst?

Typically, an analyst will have qualifications, such as:

  • A bachelor’s or master’s degree in some form of business-related studies
  • They may have professional certifications (i.e. CFA, CPA, or JD)

A small, but growing trend, is to have analysts who focus on specific sectors. These "sector" analysts may have degrees or other credentials that may be in a sector-specific area. This means that a doctor could have the academic criteria to be a pharmaceutical analyst.

Understanding the two kinds of analysts

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. This can also have an effect on their compensation.

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, a change in their rating of a company may be an indication of how they have changed 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. 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 works 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.

Understanding the ratings an analyst provides

The basic ratings of an analyst are as follows:

  • 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 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 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 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”.

How to confirm the accuracy of an analyst’s report?

Like any legal document you look at, you have to pay attention to the fine print. This will help explain how the analyst is compensated, which can provide a clue for why they gave a stock the rating that they did.

It would be easy for investors if all analysts’ ratings meant the same thing. Of course, that would also mean there wouldn’t be a need for as many analysts. The reality is that the criteria that one analyst uses to assign one stock a “hold” may be different from another analyst who sees the same data and assigns the stock a “buy” rating. This is particularly true when an analyst uses more nuanced categories such as underperform or outperform.

How individual investors can use analyst’s ratings for trading

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.

  1. Trade like Warren Buffett – one of the things Buffett famously advises is to only invest in companies that have business models you understand. Often times as investors it’s tempting to jump on a stock that is soaring or exit stocks that are falling because of the “herd mentality”. We don’t want to get left behind. However, this can lead us to invest in stocks we don’t really understand or to abandon a stock we have legitimate belief in. This doesn't mean you have to own the product. One of Buffett's most prized stocks is Apple, yet the Oracle of Omaha does not own an Apple product. It simply means that if you don't understand how the company currently makes money, how it plans to make money in the future, or if and why it has a competitive advantage than at the very least, you’ll have to do more research before acting on an analyst’s rating.
  2. 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.
  3. Be willing to change your perspective – How you perceive a stock with regard to your risk tolerance and objectives may change. 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. 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.

The final word on how your trading is affected by analysts’ ratings

An analyst is someone who is employed either by an investment institution or a trading institution to provide an objective analysis of a stock's perceived future performance. Their analysis is based on guidance provided by the company in its earnings reports and via its conference call to investors as well as specific valuation models that an analyst may use.

The traditional ratings an analyst uses are “buy”, “sell”, and “hold” although they may use additional categories such as “underperform” and “outperform” to show a broader spectrum of potential outcomes to investors.

What is important for investors to understand is that an analyst’s rating is a snapshot of a company’s performance based on their opinion. Any rating given by an analyst, especially if it is an outlier from where consensus opinions lie has to be looked at carefully in line with where the analyst is employed and how the analyst is paid. New regulations in the Sarbanes-Oxley Act of 2002 have brought more regulation and transparency to the guidance provided by analysts, but that is only in line with how the data is presented. How the data is interpreted is still at the analyst’s discretion. Even if you agree with the analyst’s rating, you have to make a buy or sell decision based on your own risk tolerance and investment objective. An aggressive growth stock that may have been perfect for your portfolio when you had 20 years until retirement, may still be attractive, but inappropriate when you are only a few years away from needing the money.

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