A lot of us pick stocks at least partly based on the analyst buy/sell rating summaries available on many financial websites?
But how reliable are those buy/sell ratings?
Surprisingly, my research found that you'd make more money buying "sell-rated" stocks than you would buying "strong buys." Here are the details.
Last week I used a backtesting site, Portfolio123 (www.portfolio123.com), to find out. Backtesting is a process that allows you to, in effect, go back in time, build a stock portfolio based on your selection strategy, and then see how your portfolio would have fared had you actually bought the stocks back then.
Although some stockbrokers and other financial sites offer backtesting features, Portfolio123’s backtesting software is much more complete and robust than anything else I’ve seen on the web. Nothing else even comes close.
For my analyst ratings backtest, I confined my universe of stocks to the S&P 500. Mainly because all S&P stocks have significant analyst coverage. To make my results reflect current conditions, I limited my test to the past five years. I set up Portfolio123 to create a new portfolio weekly and report the returns I would have received by holding each weekly portfolio for four different timeframes. four weeks, three, six, and twelve months.
Portfolio123’s software categorized the returns for each timeframe based on whether, during the timeframe, the S&P 500 moved up (up market) or down (down market). So, for each timeframe tested, say three months, Portfolio123 reports the total return, returns during up markets, and returns during down markets.
About Analyst Ratings
Analysts include a buy/sell rating when they issue a report on stocks that they cover. While the terminology varies, most ratings fall into one of these categories: “strong buy,” “buy,” “hold,” “sell” and “strong sell.” Many analysts rate stocks that they think you should sell at “hold” to avoid annoying company executives at the rated firm. Thus, savvy investors interpret “hold” ratings to mean “sell.”
Financial websites typically tabulate the ratings using this scoring system: strong buy = 1, buy = 2, hold =3, sell = 4, and strong sell =5. Thus the lower the number, the better the ratings.
I found that “strong buy” rated stocks (1.0 to 1.5) consistently underperformed the S&P over all timeframes checked. For instance, in strong (up) markets, after three months, stocks picked solely based on those ratings averaged 4.9% returns vs. 5.4% for the S&P. In down markets, “strong buy” stocks averaged 5.5% losses vs. 3.3% losses for the S&P.
“Weak buy” rated (2.0 to 2.9) stocks returned almost exactly matched the S&P 500 over all timeframes tested.
By contrast, “sell” or “strong sell” rated stocks (3.0 to 5.0), after three months, returned 5.5% in strong markets. In down markets, they lost 1.9% vs. 3.3% losses for the S&P.
So, my research found that, all else equal, at least for S&P 500 members, you’d do best holding “sell” rated stocks. You’d probably underperform holding “strong buy” picks. Of course, all else is never equal. There are many other factors that come into play.
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