Harry Domash's Winning Investing



When 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.

Why “OvervaluedStocks Outperform

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 higher.

Analyst Valuation Downgrade Resource

Need some ideas? Use this 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 your results.  

Published 5/25/17

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