- Analyst ratings are expert opinions on a company or asset's direction.
- Analysts may assign ratings from "buy" to "sell."
- Some experts rating stocks use "underweight" and "overweight" classifications.
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As a new investor, you could still form a trading strategy customized to your financial goals. As a result, getting started evaluating stocks can quickly become an overwhelming task. Stock ratings are summaries of professional financial analysis and may provide you with a starting place to evaluate a stock, ETF or other asset.
While you might already be familiar with the common "buy, sell and hold" ratings, understanding how analysts research market assets can help you better evaluate the validity of these ratings. Read on to learn how to trade using analyst ratings and what a buy recommendation could mean when assigned to a market asset.
What does an analyst do?
Before covering the importance of stock market analyst recommendations, it can be helpful to define what a stock analyst is and what they do. Essentially, the role of a stock market analyst is to do the "legwork" of research on behalf of investors, examining markets or individual company details to estimate returns. Depending on the area that the analyst works in, they might focus on specific companies or industries and evaluate their financial health, performance and prospects.
Some of the day-to-day tasks that an analyst might perform include the following:
- Financial modeling: Analysts build complex financial models based on current corporate fundamentals to forecast a company's future financial performance. These models consider variables such as revenue growth, expenses and market conditions.
- Listening to earnings calls: Analysts may listen in on earnings calls the day earnings data is released, which gives them insight into things such as surprises or disappointments resulting from the earnings report and often incorporate them into the stock analyst's recommendations.
- Economic metaanalysis: Some analysts also track economic indicators and macroeconomic trends affecting the overall stock market, such as inflation rates, interest rates and GDP growth.
Analysts often provide buy, sell or hold recommendations for individual stocks or other assets based on their research and analysis. These recommendations are often accompanied by price targets, indicating where they believe the stock's value should be. Some investment analysts use the terms "overweight" and "underweight" to replace "buy" and "hold" values.
What does overweight mean for stocks? An overweight stock rating signifies that the analyst believes the stock should perform better than the average or benchmark in the market. An overweight rating usually implies that the analyst recommends buying more of this stock in a portfolio than what would be represented by its weighting in a market index or benchmark.
For example, if a particular stock makes up 5% of a market index, an overweight rating on the stock might suggest that investors consider allocating more than 5% of their portfolio to that stock. It implies a positive outlook on the stock's potential for growth or appreciation. The opposite of an overweight rating is an underweight rating, which indicates negative sentiment and may recommend downsizing a stock's percentage makeup of a portfolio or mutual fund.
Assigning recommendations to assets isn't all an analyst does — depending on where the analyst works, making recommendations could be only a small part of the job. The two primary types of stock market analysts are "buy-side" and "sell-side" analysts.
Buy-side analysts are stock market analysts responsible for examining investments from the perspective of potential buyers. Buy-side stock recommendations are related to a specific fund or portfolio; the analyst examines potential purchases through the lens of the particular goals the portfolio is trying to achieve. Buy-side analysts rely heavily on the research done by sell-side analysts, meaning that part of the job involves determining who provides consistently valuable data on the sell-side.
For example, a buy-side analyst working for a fund like the SPDR Portfolio S&P 500 High Dividend ETF NYSE: SPYD, as the name suggests, provides its investors with a consistent stream of dividend income. Buy-side analysts working for this fund might start by identifying stocks with high dividend yields, then move on to fundamentals to ensure that the stock has the financials to continue paying these dividends or to increase payments. They might then recommend a stock or ETF for inclusion in the fund's holding list and a recommended percentage of the fund's assets to put toward it.
Image: SPYD analysts have identified more than 50 unique assets that meet its qualification for inclusion.
On the opposite side of the coin from buy-side analysts are sell-side analysts, who tend to take a more intensive approach to their research. While a buy-side analyst might start their research by scanning the entirety of a market for investment opportunities that match their selection criteria, a sell-side analyst might become an expert in a select few companies, funds or financial products. Sell-side analysts work for financial institutions such as investment banks, brokerage firms and securities research firms.
The primary objective of sell-side analysts is to provide research and insights that inform and guide investment decisions made by their clients. On a day-to-day basis, a sell-side analyst might produce reports and recommendations on various financial assets and communicate them to individual clients or institutional investors on the buying side of the equation. Most sell-side analysts earn money on a commission-based structure, meaning that the most highly paid sell-side analysts can market and sell their firm's products actively.
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 and specific issues related to a particular industry. If you're getting started investing, you might not have a full-fledged set of go-to resources for stock analysis. Relying on expert recommendations and underweight vs overweight stock recommendations can be a solid jumping-off point for new investors.
For example, the stock of a technology company 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 its rating downgraded in the future regardless of the overall market's direction. Review stock recommendations regularly if you're basing your portfolio on them, as recommendations may change as a company's business plan or financial situation does.
To become a stock analyst, you must first receive a formal financial education. Most stock analysts have:
- A bachelor's degree in a business or finance-related subject
- May have a master's degree in financial analysis, finance technology or a related subject or field
- May have other specifications, including a CFA, CPA or J.D.
A small but growing trend is having analysts focusing on specific sectors. These "sector" analysts may have degrees or other credentials in a sector-specific area. It means a doctor could have the academic criteria to be a pharmaceutical analyst, or a professor who teaches a tech-oriented class might be qualified to analyze startup tech stocks. These analysts usually also have one or more of the qualifications listed above.
Ratings an analyst provides
You'll see an analyst provide the most common ratings as the buy, sell and hold ratings. Here's what each of these stock buy or sell recommendations mean in practical terms.
- Buy: A "buy" rating is an analyst's recommendation that investors consider purchasing the stock or asset. It implies that the analyst believes the stock has the potential for future growth or price appreciation and may indicate that an asset is currently undervalued.
- Sell: A "sell" rating indicates that an analyst recommends reducing the percentage holding of a stock or asset. Analysts may assign a sell rating when concerned about the company's financial health, growth prospects or market conditions. They believe that the stock's current price does not adequately reflect these risks and that it may underperform in the future.
- Hold: A "hold" rating is a neutral rating indicating that investors should wait for more information before buying or selling a select asset. Analysts may assign a hold rating when they believe that the stock's current price accurately reflects its fundamentals and that no significant catalysts or events are expected in the near term that would drive a substantial change in its value.
Depending on the analysis source, an analyst might also provide a "strong buy" or "strong sell" rating further in the direction of the original recommendation. As we reviewed above, some analysts may also use the "overweight" and "underweight" distinctions when referring to stocks as a part of an overall fund or portfolio.
How to use analyst ratings for trading
As a beginner investor, you might feel lost when narrowing down stocks to consider adding to your portfolio. Investors can use analyst ratings as a valuable source of information and insight when making investment decisions in the following ways:
- Initial screening: Analyst ratings can be a helpful starting point for investors looking to identify potential investment opportunities. By scanning for stocks with "buy" or "strong buy" ratings, investors can quickly narrow their list of potential candidates for further research.
- Risk assessment: "Sell" or "underweight" ratings can alert investors to potential risks or issues with a particular stock or asset. While these ratings may not be the sole reason to avoid an investment, they can prompt further investigation into the reasons behind the negative outlook.
- Confirmation or contrarian indicators: Analyst ratings can also provide a sense of market sentiment if you aren’t sure what the general temperature of a company is. A stock with a buy rating from multiple analysts may indicate a positive consensus in the market. Conversely, a sell rating from multiple analysts may signal caution. Contrarian investors might use such ratings to look for opportunities that go against the prevailing sentiment, which might be a useful strategy when hedging the market.
- Investigation into new markets: If you're looking to add exposure to a new realm of the market that you aren't familiar with, analyst ratings can provide an excellent jumping-off point. For example, while tech investors might be well-versed in the technical indicators that signify a great opportunity, they may want to rely on analyst ratings more when researching the healthcare sphere for the first time.
Remember that investment ratings can change over time — so review them multiple times if you use them to invest.
Example of trading using analyst ratings
In early July of 2023, multiple analysts switched their "hold" rating on Hyatt Hotels NYSE: H after a boom in the travel industry. On July 1, 2023, shares of Hyatt Hotels were valued at about $114. On July 31, shares were valued at about $125 per share, representing an increase of about 9.65%.
Investors who put $1,000 into Hyatt Hotels at the beginning of the month and sold before the next analyst ratings were submitted saw a potential profit of about $96.
Pros and cons of using analyst ratings for trading
Using analyst ratings for trading can have both advantages and disadvantages. While they can be useful for beginning investors, they may also have limited transparency.
The pros include:
- Information before you buy: Analyst ratings provide traders with valuable insights and information about specific stocks or assets. This information can help you make more informed decisions, especially in areas you’ve never invested.
- Consensus indicator: Analyst ratings reflect financial experts' consensus on a stock's future prospects. They can quickly gauge market sentiment and consensus expectations, which is useful for short-term trading strategies.
- Idea generation: Analyst ratings can generate trading ideas. For example, a stock buy rating may suggest potential long opportunities, while sell recommendation stocks may indicate potential short opportunities.
The downsides include:
- Subjectivity: Analyst ratings are inherently subjective and can vary from one analyst or firm to another. The criteria and methodologies for assigning ratings may differ, leading to inconsistencies.
- Potential bias: Analysts working for sell-side institutions may have conflicts of interest, such as pressure to generate trading commissions or maintain relationships with covered companies. This bias can impact the accuracy of their ratings, leading to losses later down the line.
Using analyst ratings
A key point to consider when investing in analyst stock ratings is that analyst ratings may change regularly. A buy recommendation could change to a sell recommendation from one month to the next, depending on corporate decisions and earnings reports. Regularly review analyst recommendations when using them as buying decisions.
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