What does a neutral rating on stocks mean?

Posted on Tuesday, June 11th, 2019 MarketBeat Staff

Summary - At least four times every year, investors are provided with analysts’ ratings for stocks and other securities. During earnings season, companies issue earnings reports that detail their financial performance for the previous three months as well as guidance on where they see their financials going forward. These reports are scrutinized by buy-side or sell-side analysts who provide a rating of the stock. While analysts may use different terms the general categories are buy – meaning a particular stock has the potential to exceed its index or benchmark; sell – meaning a stock is expected to underperform its index or benchmark and hold. Hold is one also called neutral. A neutral rating means that analysts expect the stock to track closely to its index or benchmark over a period of time. It is neither bullish nor bearish.

From a technical standpoint, a neutral rating means that a stock is trading within a tight range. While that may not be ideal for buy-and-hold investors, day traders and options traders may find profitable opportunities if they can find clear levels of support and resistance for a stock.

Stock analysis, and particularly, the motivation behind a particular rating, has been a controversial subject for as long as ratings have existed. Neutral, or hold, ratings have become the subject of some investor ire because they are seen as being non-committal at best. And at worst, there is still a stigma of analysts who are beholden to insiders within a company who provide them with insights in addition to the guidance received by the general public. One way that investors can check the validity of any analyst’s rating is to compare it to the stock’s consensus estimate.

Introduction

Although most stocks draw attention when they are trending (positively or negatively), the majority of stocks – as well as other assets – tend to trade within a defined range. The range can be wide or narrow, but a trading range displays clear levels where a stock price receives support (i.e. the price at which the stock will not go any lower) and resistance (i.e. the price at which the stock will not go any higher). When a stock is bound within a range, analysts will term the price movement as neutral. An analyst that gives a neutral rating is speculating that a stock will trade in a range and make no significant movement above or below the movement of a market index or other benchmark. Instead of the term neutral rating, an analyst may use different names such as Hold or Market Perform. In this article, we’ll review the definition of neutral and what that rating means for investors. We’ll explain why analysts give a neutral rating and look at some trading strategies that investors can use to help them profit from stocks that have a neutral rating.

What is a neutral rating?

A neutral rating is a stock analyst rating that is neither extremely negative nor extremely positive. When an analyst rates a stock as neutral they do so with the expectation that the stock is going to trade in a tight range. For investors, this means that an analyst sees the stock as having a low growth rate. While analyst ratings are typically associated with stocks, they can apply to any tradable security including bonds, mutual funds, ETFs – even commodities. Because a neutral rating is not bullish or bearish, it is important for investors to pay attention to where a neutral rating fits in with previous ratings.

  • If an analyst reiterates a neutral rating, it is usually an indication that a stock’s price is likely to remain closely linked to a market index or other benchmark.
  • If an analyst upgrades a stock from an underperform to a neutral, it suggests that there has been some event that suggests a stock has broken out of a negative trend.
  • If an analyst downgrades a stock from neutral to underperform, it suggests that there has been something that suggests a stock has broken out of a range and is now expected to go in a negative trend.
  • If an analyst downgrades a stock from outperform to neutral, it suggests that there has been something that has, or is likely, to break a stock out of a positive trend. This does not necessarily mean the stock will trend negatively, but it is likely a signal that there will be a more neutral, as opposed to bullish, sentiment.

Like all ratings, a neutral rating is not a trading recommendation and is not always a relevant predictor of short-term stock performance. It is one piece of stock analysis that is exclusively focused on anticipated price movement. There are many stocks that can be traded profitably even after receiving a neutral rating if investors are willing to apply the proper strategies.

Why do analysts give a neutral rating?

Those who are critical of analysts' ratings, in general, will say that an analyst gives a neutral rating because they don't want to give a sell rating. In fact, a sell rating is very rarely given. A sell rating is a psychological barrier that can incite fear in many investors. Giving stocks a sell rating also puts the analyst at risk of being on the wrong side of the corporate insiders to whom they receive insight beyond the generic guidance that is available to the general public. With that in mind, there are critics who will say a neutral rating (which is equivalent to a “hold” rating) is a disguised sell. If the stock truly is not likely to appreciate significantly than investors who are looking for capital appreciation should sell it. Since an analyst rating constitutes only one part of an investor’s decision on where to allocate capital, the argument is that those investors who want to stay with the stock for other reasons (such as a dividend payment), won’t sell.

However, what is more likely the case when it comes to analysts giving a neutral rating is the fear of being wrong. In a 24/7 financial news cycle, most investors don’t need an analyst to tell them about issues that are creating headwinds for a stock. From natural disasters to trade policy and taxes there are many things each day that can affect the price of a stock. We’ve now seen that a well-timed remark from a government official can move markets. With that in mind, an analyst may be less willing to stake their reputation on a buy or sell rating – even if it can be supported by fundamental analysis – because the short-term movement may run counter to a stock’s long-term trend. If a stock that receives a buy rating drops by 5 or 10 percent after the rating is issued, an investor is less likely to remember an analyst was right about a buy rating when the stock is up 15% in twelve months.

This is why some analysts have taken to basing a neutral rating not so much on a company’s fundamentals (i.e. is their revenue up or down, what is their profit margin, have they taken on new debt, what is their free cash flow, how are their operating expenses) but on its technical price trends. In this case, a neutral rating means that a stock is trading in a tight range between areas of support and resistance. For example, company XYZ may have a 52-week high of 26.85 and a 52-week low of 24.20. This means that over the last 12 months, the stock would be trading within a range of $2.65. If an analyst feels that there is nothing in the company’s fundamentals that suggests the stock will break out of this range they may issue a neutral rating.

Trading strategies for securities with a neutral rating

As stated above, a neutral rating is not bullish or bearish. Trading when a stock is moving within a range opens up a variety of trading strategies for investors. Depending on their risk tolerance, investors can take long or short positions, including the option of going long on one stock while going short on a similar stock (i.e. one in the same sector, or with the same market cap, etc.). Range trading is also a good way to trade options or other derivative positions.

An example of a long-short strategy that is popular with hedge funds can be illustrated by using a weighted index fund. A trader can go long on the weighted components of the fund while take a short position on the overall index. This means as the index rises in price, the weighted components will rise. The short position is used to take advantage of perceived structural inefficiencies between the components of an index and the index itself. This same strategy can be taken with two companies where an investor perceives one company to be mispriced.

For options traders, covered call or covered put options are a way to profit from a stock that is trading in a neutral range. In the case of a covered call, an investor is hoping that the price will increase, but if it does not, they can still profit the option will expire worthless and the trader will still have made some profit. Conversely, with a covered put option, the investor is actually hoping that the option will expire worthless because the share price will drop. Straddles and strangles are other option trading strategies that can be used when the price of a security is expected to be neutral. In the case of a straddle or strangle, a trader will take a simultaneous short position in a call and a put on the same security with the same maturity and the same or different strike prices. While these strategies can be profitable because an investor can profit from positive and negative price movement, it can be an expensive way to trade due to fees and commissions.

The final word on a neutral rating

In a perfect world, investors would understand exactly what an analyst means when they assign a particular rating. In reality, there are a number of factors that go into an analyst’s rating. One of the most ambiguous ratings is the neutral rating. Sometimes called “Hold”, “Market Perform”, or “Peer Perform”, this rating is not definitively bullish or bearish.

One reason for this is that analysts may have different motives for giving a stock a neutral rating. On the one hand, they may be genuinely conflicted about a stock’s overall price movement. On the other, they may simply be issuing a neutral rating because they are hesitant to issue a sell rating. When this is the case, investors should take note of previous ratings. If a stock that was once rated outperform now has a neutral rating, it is important to look closely into the reasons why analysts have cooled on the stock. Likewise, if a stock has gone from underperform to neutral, it’s important to remember that it doesn’t mean the stock is going to significantly increase in value, only that analysts believe it has stopped or will stop, declining in value.

Any rating is projecting price movement over a range of time – sometimes more than a year. That means at any given time, a stock that gets a neutral rating may trend upwards or downwards. However, the idea behind the rating is that it will stay within a defined range.

However, even though a neutral rating may be considered ambiguous, it is important to note that an analysts’ rating is only one, relatively small, factor that investors need to consider when choosing a stock. Furthermore, the opinion of any one analyst should not be the most important factor in an investment decision. Even the most experienced investors can benefit from a financial advisor who can provide investment advice about the merits of owning a particular stock based on the composition of an investor’s portfolio.

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