What Does An Overweight Rating Mean?

Friday, June 25, 2021 | Chris Markoch
What Does An Overweight Rating Mean?

For an investor, the term overweight generally means that their portfolio has too much of one asset. This is a signal for them to “rebalance” their portfolio by selling some assets that are strong and putting that money into other asset classes to bring their portfolio back to its desired mix.

However, overweight means something different as it relates to an analyst’s rating system. For an analyst, overweight means that a stock is outperforming other stocks that they analyze. Since many analysts cover specific sectors having one stock with an overweight rating means that it is one of the stronger stocks in its sector.

The overweight rating came into existence after the internet bubble burst in the early 2000s. Congress and the Securities and Exchange Commission (SEC) enacted laws requiring analyst firms to take steps to provide more transparency than was available in traditional buy, sell, and hold ratings. Merrill Lynch and other firms began to introduce a new three-tier rating system of overweight, equal weight, and underweight. In addition to creating these new ratings, many analyst firms pledged to ensure their analysts would use them the way they were intended, even if it meant giving stocks an unfavorable rating.

Introduction

The stock market, like many things, has its own unique language. And for investors, it’s important to understand what specific terms mean. This is particularly true with the language of investment analysts. Sometimes the language they use can sound contradictory. One such term is “overweight.”

When overweight is used in casual conversation, it refers to something that already is. If you step on the scale and it registers a certain number you can determine if you are overweight.

Overweight can mean that in investing. Except when it doesn’t. Let me explain.

When a particular stock or asset class is referred to as overweight it can reflect the current state of that stock or asset class in regards to a specific portfolio, sector, fund, or index. However, when an analyst uses the term it can reflect what a stock or asset class should be.

This is where it can be confusing. Without context, a novice investor could assume that a stock that is overweight is one that should be sold. In some cases that is true; but in some cases the opposite is true.

In this article, we’ll take a closer look at the overweight rating. In addition to defining what the rating means and where it fits on the spectrum of ratings, we’ll go over why it has advantages as well as limitations, we’ll look at why an analyst may issue an overweight rating and review the other meanings that the term overweight has for investors. 

What Is an Overweight Investment?

First, we’ll look at the term overweight from the perspective of an investment advisor or fund manager. In this case, an overweight investment refers to a particular asset or industry sector that makes up a higher-than-normal percentage of a portfolio or index.

An index fund is a type of mutual fund that includes a portfolio of equities designed to match or track a specific market index. One of the most popular indices used by index funds is the Standard & Poor’s 500 Index (S&P 500). Another common index used is the Dow Jones Industrial Average.

The individual components of an index are weighted based on their perceived impact on the index. For example, in May 2021, Apple is one of the world’s largest companies. As of May 2021, AAPL stock carried a weighting of 5.70% in the S&P 500.

At different times indexes are adjusted to take into account new information. However, in an actively managed portfolio, the fund manager’s goal is to produce returns that outperform an index. So a fund manager may raise a particular security’s weight from 15% to 25% in an effort to increase the total return which is in line with the fund’s objective.

On the other hand, when prices are volatile, a portfolio may be “overweight” defensive stocks or an entirely different asset class such as bonds or even precious metals.

What Does It Mean When an Analyst Says an Investment is Overweight?

Now let’s look at what overweight means in the context of an analyst’s recommendation. This is the area that the rest of this article will focus on.

In this case, an analyst is not saying the stock is overweight in an index. Rather, they are making a statement about where they believe the stock should be heading. This doesn’t mean that the stock will perform the way the analyst predicts. However, the overweight indicator can be a useful directional indicator.

For example, if a company delivers a strong earnings report, an analyst may move a stock from a “Hold” to an “Overweight” rating. In this case they believe the stock has a strong likelihood to increase in price and, for that reason, take up a higher percentage of a particular index.

The Role of Overweight in Analyst’s Ratings

This is a good time to provide a refresher on analyst ratings. In a simpler time, analysts had three ratings: buy, sell, and hold. Each rating seemed to be self-explanatory. A buy rating meant that a stock’s price was expected to rise making the stock a good buying opportunity. The sell rating meant the opposite.

The problem that was dramatically made evident to investors who saw their portfolio value decline significantly in the wake of the dot com implosion is that many analysts were issuing buy ratings on stocks that were not true “buying” opportunities. Whether this was the case of novice investors failing to do their due diligence or analysts deliberately attempting to mislead investors will be debated for years. However, in the aftermath, the Securities and Exchange Commission (SEC) demanded reform and the industry has delivered.

This has led to the creation of terms such as overweight, equal weight, and underweight to signal anticipated price movement.

Why Did Analysts Create the Overweight Rating?

The overweight rating (along with its companion ratings of equal weight and underweight) was created as a response to charges that the traditional ratings of buy, sell, and hold were misleading to investors. This opinion gained critical mass after the dot com bubble burst in the early 2000s.

The realization that many of these start-up companies were “paper tigers” that had no real earnings to back up their lofty stock valuations caused outrage among investors and government regulators who demanded more transparency. The overweight, and similar ratings, are not without their detractors. Many analysts feel that the ratings are too ambiguous and don’t address the real problem of analysts who are hesitant to give even deserving stocks a rating that would trigger a sell-off.

What are the advantages of the overweight rating?

Using the word “overweight” is not the same as using a term like “buy” or “strong-buy”. Although many investors knew that those terms did not mean an analyst was making a trading recommendation, the terms were confusing to some investors.

This confusion became even more pronounced with a term like “hold” which has come to mean sell in some cases. The meaning behind overweight takes an analyst’s rating back to its intended role as a predictor of potential price movement, but not necessarily as a definitive buy or sell signal. For that, investors will need much more information.

Another advantage of the overweight rating is that, like any analyst rating, it should represent a fair comparison between two similar stocks. Because an analyst tends to cover a specific group of stocks – typically in a sector, but also perhaps in a broader category (i.e. blue chips), an overweight rating can help an investor narrow down a list of prospective stocks, particularly if they are new to that sector.

What are the limitations to the overweight rating?

One limitation to the overweight rating is the perception that it is a buy signal. Any analyst rating is an indicator of anticipated price direction. It can be bullish or bearish, but by itself, any analyst rating is not a true buy signal or sell signal.

For example, if the tech sector is down by 10%, but Amazon is only down 5%, an analyst may give Amazon an overweight rating event though the stock is down 5 percent. Does this imply that investors should buy the stock at that moment? Maybe? Then again, maybe not. Investors will need to perform much more research before making a determination on whether the stock is going through a temporary correction, or if the decline is the beginning of a longer trend.

Another limitation to an overweight rating is that the term can have different meanings to different analysts. Further complicating matters is that some analyst firms may use a broader spectrum of terms so that, while overweight may be equivalent to a “strong buy” for some firms, it may be a “moderate-buy” for another.  One way for investors to check the prevailing analyst sentiment is to look at the consensus rating for a given stock. The consensus rating takes into account the dozens of ratings that are available on any stock.

What may cause an analyst to issue an overweight rating?

Stock analysts devote a great deal of time exploring a company’s fundamentals. Although all companies must provide detailed financial documents as part of their quarterly earnings, many analyst firms have their own systems for evaluating fundamental metrics such as a company’s current ratio or their return on equity.

If the company beats the previous quarter’s estimates – and they appear to be adhering to the generally accepted accounting principles (GAAP) that is usually a bullish signal for analysts. Analysts will also look at the “guidance” provided by companies. These are forward-looking statements that every company issues in an attempt to manage investor expectations for the upcoming period or periods. In some cases, companies will use this as an opportunity to lower expectations and begin to explain why. In other cases, they may use this as a chance to take a “victory lap” and to stoke investor interest.

Another bullish signal is if a company continues to issue, and/or increase, an existing dividend. One reason for this is that analysts know that once companies start to issue dividends they are generally reluctant to stop issuing them.

Other reasons may include a shift in government policy that will be more favorable to the sector. A good example of this is the continuing passing of ballot initiatives that have legalized the medicinal, if not recreational, use of marijuana and is causing the corresponding stocks to rise. Likewise, natural disasters have a way of generating winners and losers.

The final word on overweight ratings

An overweight rating is generally considered a bullish signal for a stock because it is outperforming other stocks that are covered by an analyst. Although an overweight rating does not necessarily mean a stock is “in the black” it does mean that it is showing strength even if it is in an underperforming sector.

The overweight rating has provided clarity for some investors simply because it is making clear that the analyst is only talking about price performance and not making, what could appear to be, a buying or selling recommendation. Critics however say the definition of the term overweight leaves too much room for interpretation and can allow analysts to give the stock an overweight rating for stocks that are simply the “tallest of the seven dwarfs”. To help check the validity of an analyst rating, investors should look at the consensus estimate for a stock which will help them see what the prevailing sentiment is for a given stock or security.


7 Stocks to Buy Now and Avoid a Summer Swoon

Summer is generally a quiet time in the markets. Institutional investors, generally speaking, take some time away. In fact, that’s where the idiom “Sell in May and Go Away” comes from.

But quiet doesn’t mean uneventful. The world still moves along even in the lazy months of summer. And at the moment, there are two conflicting views driving the market.

One is the fear that everything’s a bubble that is just about to burst. We don’t recommend you get out of stocks, but let’s face it, things are more than just a little frothy.

But there’s another view summarized by the acronym, YOLO (as in You Only Live Once). And these investors are committed to keeping the markets going higher. Even if it means going “all in” (whatever that means to them) on risky asset classes like NFTs or Dogecoin.

We sincerely hope you take time to recharge (whatever that means to you) this summer. Whatever your personal beliefs, the reopening of our economy is a moment that deserves to be celebrated by all of us. But before you do, we recommend that you take a peek at these seven stocks that you can consider adding to your portfolio before you check out for the summer. These are likely to get as hot as a firecracker on the Fourth of July and should have you smiling when the summer ends.

View the "7 Stocks to Buy Now and Avoid a Summer Swoon".


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