Financial analysts who are employed by investment firms research stocks and provide their opinions to investors about their possible future performance. Their opinion takes the form of a rating. An Underweight stock rating indicates to investors that it may not be a good investment. In other words, if a stock is rated by Wall Street financial analysts as an Underweight stock, it is expected to have a lower return than other stocks in its market sector. Consider working with a financial advisor to take full advantage of stock ratings.
Why Is a Stock Rated Underweight?
An Underweight stock rating is the opinion of a financial analyst that the stock will underperform other stocks in its market sector or in a market index, usually over the next six to 12 months. Other financial analysts may have different opinions. Investors should read the justification written by each analyst for assigning an Underweight rating before deciding not to invest in that stock.
Analysts give Underweight ratings when they see forecasts concerning a company’s growth in earnings. If there is going to be a slowdown in earnings, that is a red flag. But it is important for investors to find out why there is going to be a slowdown in earnings growth. Investors should make their decisions based on not only an analyst’s recommendation but their own research and investment time horizon. If the analyst’s Underweight rating is only for the next six to 12 months and you are an investor with a long-term time horizon, you might want to just hold it if it is already in your portfolio. This will keep you from experiencing tax consequences and increased transactions fees.
Analysts must be able to justify designating a stock as an Underweight stock since such a ranking will affect investor behavior. Investors will think an Underweight stock will negatively affect their portfolio returns and sell the stock. This will drive down the stock price. Portfolio managers may decrease the weight of the Underweight stock in their portfolios in order to avoid decreasing returns. Even if an Underweight stock is in a portfolio, it may provide diversification and investors might want to hold on to it for that reason.
A stock given an Underweight rating is probably experiencing stagnant or declining earnings. It could be failing to meet quarterly earnings expectations. There are a number of possible scenarios that could contribute to stagnant or declining earnings including an economic slowdown or political upheaval. Look to the company’s earnings guidance for help above and beyond the analyst’s ratings
In the lingo of the finance world, there are other terms an Underweight stock may be called. It may just be called a Sell. Other terms you should recognize are Reduce and Underperform.
Understanding the Ratings Systems
There are two primary ratings systems for securities. There is a three-tier system and a five-tier system. The three-tiered system is the one that uses the Underweight rating. The other two tiers are Overweight and Equal Weight. The second system is a five-tiered system. The five-tiered system ranks stocks based on a scale. Along the scale are five possible rankings: Strong Buy, Buy, Hold, Underperform and Sell.
Different investment firms and analysts may define these categories differently. For example, a Sell rating might be defined by an analyst as a stock that is expected to perform 25% worse than the market. Another analyst might define a Sell recommendation as a stock that will perform 15% worse than the market for the next six to 12 months. More common than Sell is a Hold or Underperform recommendation. To compare the two systems, an Underweight stock rating usually falls somewhere along the scale between Hold and Sell.
Benchmarking Against the Market Index
The stock market is represented by a number of market indices that track the performance of both the broad market and specific segments of the market. The Standard and Poor’s 500 index is a widely used market index that includes the stock of 500 of the largest companies. This index is popular because it is a widely held opinion that it may represent the market most accurately. Each stock in the index has a weight based on its market capitalization. When a stock is rated as Underweight, the analyst is effectively saying that the stock deserves a lower ranking in its index.
Morningstar also has a ratings service. This service focuses more on ranking mutual funds according to its criteria than stocks although it does also rank stocks.
Also, the choice of the right market index with which to compare a stock is crucial. Some indexes use weighting systems based on factors other than market capitalization. There are many market indices from which to choose that represent nearly every possible classification of stock and market sector.
Investing in Underweight Stocks
Investors should use a number of criteria before they rate a stock as an Underweight stock. There are some 7,500 analysts on Wall Street. They have different opinions regarding whether to rate a stock as Underweight. They may have a different risk preference than yours or they may have different investment time horizons. There are many variables and techniques in stock valuation. Consider more than one or two financial analysts’ opinions before you invest.
An Alternative Definition of Underweight Stock
In a portfolio context, the word Underweight may be used if you have more of a specific stock in your portfolio than exists in the market index. If you own 3% of a stock that has a 6% weight in the market index, you are said to be Underweight on the stock.
The Bottom Line
The ranking systems for stocks look simple. The analysis that goes into finally determining the rank of a stock as Underweight is anything but simple. A wide variety of factors are taken into account by financial analysts and they may have differing opinions. Analysts’ recommendations should only be used as suggestions regarding your investment decisions. There are other factors to consider such as the valuation of the stock, your own risk preference, the company’s earnings guidance and your investment time horizon.
Tips on Investing
- It’s a good idea to work with a financial advisor on choosing investments for your portfolio. Finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool can help you connect with a professional advisor in your local area in minutes. If you’re ready, get started now.
- In order to help you construct your investment portfolio, try out SmartAsset’s asset allocation calculator. You can enter your risk tolerance and get some help in choosing securities for your portfolio.
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