What does an outperform rating mean?

Posted on Tuesday, June 4th, 2019 MarketBeat Staff

Summary - Outperform is an investment rating that analysts assign to investments (usually stocks) that they expect will provide returns that will exceed a benchmark index or other market average. An outperform rating is considered to be a bullish rating and is sometimes synonymous with ratings such as “moderate buy”, “accumulate”, “add”, “market outperform”, or “overweight”. An outperform rating can be based on a stock index, such as the S&P 500 or the Dow Jones Industrial Average (DJIA). It can also be based on stocks within a specific sector (technology, utilities, etc.) or that share similar characteristics such as market capitalization (small cap, large cap, mid-cap).

Although a rating of outperform can be a downgrade from a “strong buy” for analysts who use that rating, it is generally considered to be a strong signal that the particular stock is a good buying opportunity. In fact, some analysts may even use outperform in place of strong buy. This brings to mind a key point about the outperform rating and, in fact, all analysts ratings. To truly understand what outperform means investors must understand the context in which the rating is being used. For some analysts an outperform rating may be closer to a “strong buy” for others it may simply be their “buy” rating. One of the best things an investor should do is look at the analysts’ consensus estimate. In some cases, an outperform rating may be an outlier while, in other cases, it may reflect the prevailing sentiment among market analysts.

Introduction

One of the most favorable ratings an investor can see for a stock is outperform. Although the outperform rating, like any rating, is a signal of price movement. Outperform is a bullish signal that indicates that a stock is expected to produce higher returns than major market indexes for an extended period of time. In this article, we’ll take a closer look at the outperform rating. We’ll review some of the reasons a stock may outperform. We’ll also show how outperform fits into the spectrum of analysts’ recommendations and we’ll show investors how they can use proprietary tools from financial web sites to confirm the accuracy of an analyst’s recommendation.

What does an outperform rating mean?

When an analyst gives a stock an outperform rating, it is an indication that the analyst expects the stock to beat the market or market index for that stock. In some cases, it may mean that the stock will outperform other stocks in its sector which may be defined by market capitalization, industry, or other characteristics. For example, the Invesco QQQ is an exchange-traded fund (ETF) that is an index fund for technology stocks that trade on the NASDAQ stock exchange. If the fund is up 8%, but Facebook (FB) is up 10%, Facebook would be said to be outperforming the market by two percentage points. 

Like many ratings, the outperform rating can have different names depending on the analyst. Other names include: market outperform, overweight, or strong buy. In some cases, an analyst may not have an outperform rating and will simply rate the stock as a buy.

What can cause a stock to outperform?

Some of the most common reasons for a stock to outperform the market are:

  1. Faster than expected growth in revenue or earnings.
  2. The company announces they are raising their dividend.
  3. A rebound falling a period where the stock had been undervalued.
  4. The stock is in a sector that is under pressure due to market conditions.

Point number three brings to mind an important consideration about an outperforming stock. The outperform rating should not be confused with the concept of an asset outperforming the market. That’s because outperforming the market does not always mean a positive return. For example, if the Nasdaq Composite Index is down 20 percent, but Amazon is only down 13 percent, then Amazon is said to be outperforming the market. However, an investor with money invested in Amazon would still see the value of Amazon’s stock in their portfolio decline. However, it will decline less than a fund that was tied to the NASDAQ index.

In a similar way, a stock can outperform its peers. For example, an investor could look at the stock of Lowe’s and Home Depot. If one is significantly higher than another, that stock could be said to be outperforming that stock. However, that does not necessarily mean the stock will have an outperform rating.

Understanding the language of analysts

There are buy-side analysts and sell-side analysts. Buy-side analysts work at investment firms such as a mutual fund company. They will typically have money in the stocks they analyze. 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 analysts 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.

Whatever side an analyst is on, the job of an analyst is to do the legwork for investors. 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.

In the past, an analyst recommendation would be a buy, a hold, or a sell. However, those ratings became insufficient for a new generation of investors who are looking for more detailed ratings that help explain anticipated price movements.

Here is a look at the spectrum of analysts’ recommendations:

 

More bearish

 

More bullish

 

SELL

 

HOLD

 

BUY

 

 

Underperform

 

Outperform

 

Other words used to mean the same or similar

Strong Sell

Moderate Sell

Neutral

Moderate Buy

Strong Buy

Weak Hold

Market Perform

Accumulate

 

Underweight

Sector Perform

Overweight

 

Reduce

Peer Perform

Add

 

 

You can see that a rating of Underperform or Outperform does not clearly advocate selling or buying. Rather the ratings give directional advice such as reducing a position or adding to a position. Some analysts do in fact only use Outperform and Underperform with some term in the middle (i.e. neutral, market perform, etc.). However, some will use those terms with a Strong Buy rating on one end or Strong Sell rating on the other. And, keep in mind that some analysts do not use the exact term Outperform.

To further illustrate this, let’s look at some actual ratings by Wells Fargo:

6/3/19 – Downgraded Five Prime Therapeutics (FPRX) from Outperform to Market Perform

5/31/19 – Upgraded Molina Healthcare (MOH) from Market Perform to Outperform

5/30/19 – Lowered Target on PVH (PVH) but kept the stock as an Outperform

5/24/19 – Downgraded Spire (SPR) from Outperform to Market Perform

5/23/19 – Raised Target on Iovance Biotherapeutics (IOVA) but kept the stock as an Outperform

Each of these ratings tells a different story to investors. One of the first things to understand before trying to interpret what these ratings mean is that Wells Fargo uses a variety of ratings in addition to Market Perform and Outperform including Buy, Sell, Hold, and Neutral.

In the case of Five Prime Therapeutics (FPRX), the stock was downgraded and analysts suggested that this would have a high impact on the stock price. In the past three months, the stock has lost nearly half its value dropping from a high of over $13 to a price of just under $7 as of early June, putting the stock in the low end of its 52-week high-low range.

Molina Healthcare (MOH) was given an upgrade which was also expected to have a high impact on the stock price. In the month prior to this rating, the stock had jumped almost $20 per share bringing it from the middle to the upper end of its 52-week average. This would suggest that analysts believe that the stock may not only test but exceed its current 52-week average.

Conversely, Spire (SPR) was downgraded from Outperform to Market Perform. However, in this case, analysts anticipated this to have a low impact on the stock price. This is because they retained the price target which suggests that Wells Fargo views Spire to be trading within a tight range.

The case of PVH (PVH) is interesting. Although the analysts maintained their Outperform rating, they lowered the price target from $140-$120. Despite lowering the price target nearly 15%, they expected the rating to have a low impact on future price movement. PVH’s stock has been battered recently and is currently well below the $120 price target. This means that, in this case, analysts are seeing the stock as oversold and a good buying opportunity.

Conversely to PVH, Wells Fargo raised their price target on Iovance Biotherapeutics (IOVA) from $23-32 and kept the stock as an Outperform. Despite raising the price target, it was expected to have a low impact on their stock price. A closer look shows that the stock is currently near its 52-week high at just under $19 per share. This suggests that Wells Fargo is projecting that this rating is taking a long-term view of the stock’s potential.

These cases illustrate why investors will want to perform additional fundamental and/or technical analysis to determine what the upside potential is for each stock.

How can investors find outperforming stocks without using analyst ratings?

Many of the financial investing publications have proprietary stock analyzing tools. For example, Investor’s Business Daily has their IBD Composite Rating. Stocks with a composite rating of 95 or higher are likely to outperform the broader market. The Composite Rating is a relative index which means that a stock with a score of 93 is outperforming 93% of all stocks in the areas that IBD measures. The composite rating ranges from a rating of 1 (represents the worst) to 99 (best). The Composite Rating is an overall score that is based on the grade a stock may receive in four of what IBD calls their SmartSelect Ratings that include:

  • Earnings per Share (EPS) Rating– which tracks annual and quarterly earnings
  • SMR Rating– which measures sales growth, profit margins and return on equity
  • Relative Strength (RS) Rating– provides an analysis of a stock’s relative price strength compared to the S&P 500.
  • Accumulation/Distribution Rating– tracks the level of buying and selling of stocks by institutional investors over the previous 13 weeks

The final word on the outperform rating

The outperform rating is one of the more bullish ratings that analysts can use. When a stock is projected to outperform, analysts are suggesting that the stock should move higher than its current price. An outperform rating from one analyst should always be checked against the consensus analyst ratings to determine if it is the prevailing sentiment among analysts.

The key to understanding the outperform rating is to understand:

  1. Why the stock may be outperforming?
  2. What the stock is being benchmarked against (an index, a sector, companies of similar size, etc.)?
  3. Does the rating come with an adjusted price target? Where does the new price target fit with the stock’s historical and/or 52-week average?

Some analysts will use the outperform rating as the high end of their recommendations. Others will use it as one of many bullish indicators that may include, buy and strong buy. Investors can find tools such as the Composite Rating from Investor’s Business Daily to give them a confirmation of an analysts rating.

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