Sell Means Buy
A stock analyst’s ratings downgrade, say from “buy” to
“hold,” which savvy market players understand means “sell,” usually
drives the share price down. But the downgrade could be a buying
opportunity if valuation was the main the reason for the rating change.
I recently tracked the share price action of a group of
stocks that were downgraded to “hold” or “sell” primarily because the
analyst thought they were overpriced.
Valuation Downgrades Doubled the S&P Returns
I found that six months after the downgrade, the
valuation-downgraded stocks had averaged a 20% return (price changes
plus dividends), double the S&P 500’s 10% return over the same period.
By comparison, a second group of stocks downgraded for reasons other
than valuation, averaged a 7% return.
Thus, I found that stocks downgraded for valuation
reasons outperformed the S&P 500, while stocks downgraded for
non-valuation reasons underperformed.
While my research was hardly rigorous by academic
standards, the results were consistent with similar research that I
reported on in these pages almost 12 years ago (October 30, 2005) when I
found that, over a six month period, 11 valuation-downgraded stocks
averaged a 12% return vs. 3% for the S&P 500.
Recent Research Details
Both of my test portfolios included only stocks
downgraded to “hold” or “sell” during September 2016. I picked September
for two reasons: 1) it was six months back, a reasonable timeframe for a
stock to recover from a valuation downgrade, and 2) the S&P ended
September almost exactly where it started, so I didn’t have to adjust
the individual stock returns depending on when they were downgraded
during the month.
My valuation-downgraded portfolio included 16 stocks,
which was all that I could find. More than 100 stocks were downgraded
for non-valuation reasons during September, but to save time, I picked
only 31 stocks to track, basically all stocks downgraded on four
randomly selected dates. For each stock, I tracked the returns from the
downgrade date through April 25, 2017.
Analysts use various formulas to compute target prices
(fair value) for stocks that they follow. Their buy/sell ratings depend
on how a stock’s current trading price compares to the target. That is,
stocks trading substantially below the target get “buy” ratings while
those trading above are “holds” or “sells.”
While details vary, all target price formulas depend
heavily on the analyst’s earnings and/or cash flow
forecasts to compute fair value. Thus, calculated target prices
would move up when a firm reports earnings above forecasts, or gives
analysts other reasons to raise earnings or cash flow
forecasts. The higher target prices, of course, allow analysts to
up their ratings back up to “buy,” which typically moves trading prices
Analyst Valuation Downgrade Resource
Need some ideas?
link to trigger a
Google search for recent analyst valuation downgrades.
A valuation-downgrade doesn’t guarantee that a stock is
headed up. Many other factors could come into play. You still have to
do your due diligence. The more you know about your stocks, the better