Understanding Underweight Stock Ratings

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.

What Does an Underweight Stock Rating Mean?

An Underweight stock rating reflects a financial analyst’s opinion that a stock is likely to underperform its peers within the same market sector or a broader market index, typically over the next six to 12 months. However, not all analysts share the same view, so it’s essential for investors to review the reasoning behind each Underweight rating before making investment decisions.

Why Analysts Assign Underweight Ratings

Analysts usually assign an Underweight rating when they anticipate challenges in a company’s earnings growth. A forecasted slowdown in earnings is a potential red flag, but it’s critical for investors to investigate the root cause. Factors such as economic conditions, industry trends or company-specific issues might contribute to this outlook.

Before reacting to an Underweight rating, investors should consider their own investment strategy and time horizon. For instance, if an analyst’s projection of underperformance spans the next six to 12 months but you have a long-term outlook, selling the stock might not align with your goals. Holding the stock could help you avoid unnecessary tax liabilities and trading fees.

The Impact of an Underweight Rating

When a stock is rated Underweight, it can influence investor behavior and market dynamics. Investors may interpret the rating as a signal to sell, which can lead to a drop in the stock price. Portfolio managers might also reduce the stock’s allocation to minimize potential drag on returns. However, even an Underweight stock can offer benefits like portfolio diversification, so it may still warrant a place in your holdings depending on your strategy.

Understanding Stagnant or Declining Earnings

Stocks with an Underweight rating are often experiencing flat or declining earnings or failing to meet quarterly expectations. This could stem from various factors, including:

Economic slowdowns
Industry disruptions
Political or regulatory changes

Investors should review the company’s earnings guidance in conjunction with the analyst’s rating to better understand the situation and make informed decisions.

Other Terms for Underweight Stocks

In financial analysis, Underweight is one of several terms used to signal caution about a stock. Similar terms include Sell, Reduce and Underperform. Recognizing these labels can help investors interpret analyst recommendations more effectively.

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.

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.