Analyst rankings are an important sentiment indicator that we like to use here at Schaeffer's, since they're a quick way to gauge how Wall Street is feeling toward a certain stock. Analysts frequently use different ranking systems based on the preferences of their specific brokerage firms. For our purposes, we typically refer to these rankings in five broad categories: strong buy, buy, hold, sell, and strong sell. Depending on the brokerage firm, these categories may be denoted differently – for example, some brokers use the term "neutral" instead of "hold," or "underperform" instead of "sell" – but the underlying message remains the same.
In the simplest terms, "strong buy" and "buy" ratings are bullish, while "sell," and "strong sell" ratings are all considered bearish. Due to a general reluctance on the part of Wall Street to issue “sell” ratings, “hold” opinions are also considered to be a bearish point of view. Analysts generally use a combination of technical and fundamental data to arrive at their ratings on a given stock, considering such factors as earnings, valuation, new products, management changes, and a plethora of others.
A quick assessment of a stock's analyst rankings will provide a snapshot of the Street's current sentiment on that security. If an equity is carrying 7 "strong buys," 5 "buys," and 2 "holds," it's safe to say that brokerage firms are overwhelmingly optimistic toward the stock. Conversely, a wealth of "hold" and "sell ratings reveals brokers' pessimism toward a security.
These ratings become a source of particular interest to us when they're adjusted, since analyst upgrades frequently result in buying pressure, whereas analyst downgrades often lead to selling pressure. However, the end result of an analyst rating change can depend in large part on a number of other factors, such as the degree of the change and the corresponding investor sentiment toward an equity.
For example, an upgrade from "buy" to "strong buy" may not result in too much upward momentum. The change is essentially a shift from bullish to more bullish, and doesn't represent a significant change of heart from the analyst. The stock could still post gains as a result of the upgrade, but they'll likely be more modest than if the stock had been raised from "sell" to "buy" – representing a substantial turnaround in the broker's opinion. By the same token, a downshift from "hold" to "sell" will likely send a stock spiraling lower than a downgrade from "sell" to "strong sell."
Of course, we must remember that in order for buying pressure to come into the picture, there must be a sufficient amount of sideline buyers available – just as a large number of potential sellers must exist for heavy selling pressure to come into play.
Let's use the example of Standard Company. The stock has 5 "strong buys" and 2 "buys," along with 1 "hold" rating. During the past year, the shares have rocketed 200% higher, and investors are overwhelmingly enamored of the stock. If that one skeptical analyst upgrades the stock to "buy" from "hold," it's entirely possible that the stock will fail to tally any major gains as the result of the upgrade, since so many investors are already crowded onto the bullish bandwagon.
Of course, the same holds true for oversold equities. If the final remaining bullish analyst covering a downtrending stock shifts his or her rating from "buy" to "hold," it could be true that most investors have already fled for the exits, and the stock's price could remain relatively unchanged by the news.
On the other hand, a stock that's the target of negative sentiment from investors stands to benefit greatly from an analyst upgrade. The positive attention from Wall Street may cause some bears to reconsider their positions – or, in the case of short sellers, to exit their positions to control losses. As long as investor sentiment indicators reveal a healthy level of investor pessimism – such as inflated short interest or a high-ranking Schaeffer's put/call interest ratio – a stock can usually benefit from analyst upgrades. So, the potential positive or negative effects of an analyst rating change must be considered in light of investor sentiment and the given equity's price action.
Additionally, relatively new or undiscovered stocks can benefit from new analyst attention. Sometimes, a stock with light analyst coverage can even gain from being initiated with a "hold" rating, by simple merit of the fact that investors now have reason to pay attention to the shares.