What does an equal weight rating mean?

Posted on Tuesday, June 11th, 2019 MarketBeat Staff

Summary - For many years, investors were left with three ratings that summarized an analyst's opinion of a stock: Buy, Sell or Hold. The problem with these ratings is that they can be confusing, and possibly misleading. But what became evident after the dot com bubble burst in the early 2000s, was that too few analysts were issuing "sell" ratings. Tasked with finding a better solution, many companies have come up with a broader spectrum of ratings that include the words (or a version of) overweight, equal weight, and underweight. These words have different meanings in the investment community. As they relate to an analyst's rating, they imply how well a particular stock performs relative to the other stocks that an analyst reviews. 

With this as background, an equal weight rating suggests that a stock will perform in line with the average of all the stocks that analyst may cover. For example, if an analyst covers the technology field they most likely cover all of the FAANG stocks. If the tech sector is showing an overall growth of 10 percent, and Facebook is also at 10 percent, then Facebook would be seen as having equal weight. Conversely, if a sector is down five percent and an individual stock within that sector is down only two percent, it may be seen as being overweight. These scenarios show why any rating system, no matter how transparent it attempts to be, is always only one metric that investors should use.

Introduction

If you were an investor in the early 2000s, you don’t need to be reminded of that sick feeling you may have had as you watched years of capital gains erased in a matter of weeks and months. It was a time that left many investors wondering how analysts and financial advisors could have been so wrong. The problem touched on a systemic issue among stock analysts – a rating system that did not place a premium on transparency. Too few analysts were willing to give stocks a negative rating. Faced with a loss of credibility, and increased government regulation, many institutional investors took preventative measures to help provide a rating system that was more transparent and more descriptive of the anticipated price action. A common solution has been a three-tier rating system with overweight, underweight, and equal weight designations. This article will go into detail about the equal weight rating. In addition to reviewing its advantages and disadvantages, we’ll review what may cause an analyst to issue this rating and why it should not be confused with equal weight index funds.

What does an equal weight rating mean?

When an analyst gives an equal weight rating, they are expecting a stock’s performance to be in line with the average return of the other stocks that the analysts cover. Since many analysts cover entire sectors, these stocks will tend to be similar in terms of market capitalization and in the way they match an investor’s investment objectives (i.e. growth, income, growth and income, trading/speculation) and risk tolerance. The equal weight rating is typically the middle rating in a three-tier system that includes overweight (which loosely means buy) and underweight (which loosely means sell).

Why did analysts create the equal weight rating?

The equal weight rating was created in large part as a response to the internet bubble that popped in early 2000 and saw many investors see significant declines in their portfolio in a matter of weeks or, in some cases, days. Wall Street stock analysts and their firms received harsh criticism for what was seen as a practice of posting ratings on stocks that were overly optimistic at best and, at worst, outright misleading. In the wake of the spectacular collapse of many dot-com companies as well as a company like Enron, Congress demanded that analysts not only create a more descriptive rating system but actually use the system to give a more accurate view of a stock's share price movement.

Morgan Stanley was one of the first brokerage firms to respond to this by creating a new three-tier rating system consisting of overweight, equal weight, and underweight ratings. The new ratings were created to give investors more transparency into what an analyst’s rating meant. The intent was to “ensure a stock’s rating would factor in the perceived risk in the shares relative to others in its sector”.

Prior to adopting the new ratings, Morgan Stanley had previously used: strong buy, outperform, neutral and underperform. At the time of the change, executives at Morgan Stanley said the firm decided to use the new terminology because the conventional buy, sell, and hold ratings were misleading because they imply that investors should take an action that may be true for one investor, but not another.

The advantages of an equal weight rating

An equal weight rating is more likely to provide investors with an “apples to apples” comparison. Analysts are typically assigned to cover entire sectors (technology, utilities, pharmaceuticals, etc.) Because an equal weight rating implies that a stock is being measured against others that an analyst covers, investors understand that the stock is being compared, relatively speaking, to its peers and not to an index which may include stocks that are less comparable, even if they share a similar market capitalization.

Also, an equal weight rating clearly defines the rating as being about price movement rather than implying that an investor should take a particular buying action. The traditional “buy”, “hold”, or “sell” ratings – while not intended to be seen as endorsing an action for every investor in every situation – can be confusing to novice investors.

The limitations of an equal weight rating

It's almost impossible for an analyst to get around the perception that they are painting a picture of stocks that is overly optimistic. Nevertheless, even firms that adopt a "weighted" rating scale can still face criticism that the equal weight rating can be an easy "catch-all" for stocks that they see as having poor growth prospects. Rather than tagging it as underweight (which may be perceived as a sell signal), thus potentially damaging their relationship with corporate insiders, an analyst could pivot to a more neutral rating that would be seen as less controversial.

Another limitation of the equal weight rating is that the words “equally weighted” can mean different things to different analysts. One way that investors can help to clarify the overall opinion of a stock is to look at its consensus estimate. Every stock, particularly during earnings season, is analyzed by dozens of analysts. By looking at the consensus rating, investors can get a sense of the strength of opinion among analysts regarding the stock.

Also, although an equal weight rating is, by definition, neither bullish nor bearish, it can be predicting a coming trend. Since publicly traded companies release earnings reports on a quarterly basis, investors have the ability to compare an analyst’s rating from one quarter to the next to get a sense of where the stock price is headed. It may be that an equal weight rating has been reiterated for several quarters – which indicate that the stock is not showing a definite pattern. However, if a stock was underweight and moves to equal weight, or conversely was overweight and now moved to equal weight, it could be a sign that an existing trend is about to reverse. In this way, an equal weight rating can be a buy or a sell signal.

What may cause an analyst to assign an equal weight rating?

Stock analysts are just one component of an investment firm’s research staff. One of the key responsibilities of these analysts is to look closely at a company’s balance sheet – which is part of the financial disclosures that every company is required to provide as part of their quarterly earnings report – to look for metrics that can affect a stock’s performance. In addition to looking at the company’s revenue and profit figures, they may use their firm’s proprietary methodology to perform calculations for ratios such as earnings per share (EPS), the price to earnings ratio (PE ratio), return on equity, net margin, and free cash flow. Although many companies will follow Generally Accepted Accounting Principles (GAAP) standards, some – for a variety of reasons – will not.

It would seem to be self-evident that an equal weight rating means a company “met” expectations, and that will certainly be true in some cases. However, there are times when a company may beat expectations or fall short of them, yet still, receive an equal weight rating. This is why, in addition to scrutinizing the balance sheet, a stock analyst will talk to executives in the country and listen for what they are saying, and not saying, about the company’s mid- to long-term outlook. Perhaps a company that just reported weaker profits did so because they accelerated buying in anticipation of higher material costs. Likewise, a company that reported strong earnings may be facing a stiff regulatory challenge that could take months to resolve. These are just a couple of examples of why the numbers don’t tell the whole story.

Other things an analyst may look for include a company's dividend. Are they issuing one? If so, is it for the same amount – less or more? Is the company releasing a new product? Are they facing a competitive threat? All of these factors and more go into an analyst's decision to give a stock an equal weight rating.

For fund investors, equal weight has a different meaning.

For mutual funds, the concept of equal weight may have a different meaning. This is due to the emergence of equal weighted index funds. An equal weight mutual fund (or equal weight ETF) strives, as much as possible, to invest the same amount of capital in each company that makes up the index (i.e. every company receives the same weighting). This is a very different approach from traditional capitalization based index funds which assign weighting to the amount of money that is invested in the fund with the largest companies making up the highest percentage of the index. The methodology behind an equal weight fund is one of value as opposed to momentum. This can be contrary to how many investors perceive fund investing. Equal weight funds tend to be more volatile. As a consequence, investors may notice they fall more during recessions but have stronger rebounds in bull markets. However, if investors are willing to put up with the volatility, history is showing that (as of this writing) many equal weight funds, such as the Invesco S&P 500 Equal Weight ETF (RSP) are outperforming their counterpart cap-weighted funds.

The bottom line on an equal weight rating

An equal weight rating is part of an analyst ratings system that suggests an individual stock’s performance will be closely tied to the average of all the stocks that an analyst covers. Since most analysts cover specific sectors, this rating helps investors get an “apples to apples” comparison. An equal weight rating on an oil and gas company from an analyst that covers all the utility stocks will tend to carry more credibility for investors. The significance of an equal weight rating depends on the context of the rating. If a stock has been underperforming for a long time and is upgraded to equal weight, this can be a bullish sign for investors. However, if a stock continues to keep pace with a weak sector than an equal weight may be a bearish sign as it is unable to separate itself and shows little opportunity for immediate capital gains.

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