Analyst Upgrades and Downgrades – What They Mean

by JT McGee

There are thousands of equity analysts out there who do nothing more than value companies all day. I can’t describe how envious I am of their day jobs.

The equity analysts’ job is to:

1. Forecast the future of the business and its business lines.
2. Assess competitive threats and emerging risks.
3. Measure the riskiness so that it can be quantified in the discount rate (how aggressive earnings in the future are discounted at present.)
4. Come up with a value for the company.

Upgrades and Downgrades vs. Price Targets

The most actionable part of an analyst rating is the price target. You see, the headlines often read “X company is downgraded by X firm.”

Depending on the name of the firm, this has varying effects on the stock price. A well known firm that manages substantial amounts of capital is going to move the markets more than another. Of course, this is all relative. Even smaller firms like Feltl & Co. (I hadn’t heard of them, either) sent Metropolitan Health Networks down 10-15% on a downgrade from strong buy to buy in August.

Downgrades or upgrades are related entirely to the price target. For instance, if an analyst believes a stock is worth $12 per share, then he’s not going to rate it a buy at $11 – it’d be more like a hold. Likewise, if an analyst thinks a company is worth $12 and trading for $6, that’s going to be a strong buy.

So, whereas the market moves based on upgrades and downgrades, the really important part is whether or not you’re buying more company than you should be able to buy. If a company with an intrinsic value of $12 is selling for $6, you’re getting more for your money. Remember, securities analysis is all about determining whether or not a company is a good value based on the whole market. A cheap stock isn’t cheap if the whole stock market is cheap; nor is a stock expensive (well…) if the whole stock market is expensive.

Should you listen to equity analysts?

Whether or not you should listen to analysts is up for debate. Personally, I try not to, mostly because I don’t want their analysis influencing mine.

I think what we all have to remember is that analysts are paid to value businesses. They are not paid to value businesses they want to invest in. So, suppose an analyst would never invest in…say, Intel because he or she isn’t all that confident in the future of technology or the management, or whatever it is. That analyst still has to give a value to the company.

If analysts were to give valuations only to companies they really liked, I think their analyses would be far more meaningful. I’d be willing to bet that analyst’s favorite picks of their watch group significantly outperform their least favorite. The problem is that neither you nor I have any way of knowing which companies they really believe in and which they don’t really like. Or which analyses they are least confident in. Fact is that any stockpicker knows when they find that one easy to value, easy to understand business. And they know how different it “feels” from a company that is hard to analyze.

You guys know I hate investing in companies in industries that are in constant flux. I avoid them like the plague with my own money. But if I were an analyst, I wouldn’t have a choice but to analyze the companies that my employer tells me to analyze. And you can’t exactly publish a report that says “hey, I don’t know how to analyze this” because no one gets paid for doing nothing. So realize that just because an analyst rates a company as a buy that doesn’t mean they’d put their own money into it.

Anyway, that’s just the lowdown on analyst upgrades and downgrades.

{ 4 comments… read them below or add one }

American Debt Project December 13, 2012 at 19:40

In my investments class (way back in college), my professor dismissed analysts, claiming that the best analysts only stayed for a couple years before moving onto better things, which I assume is managing a hedge fund or a private equity firm. You’re right, I can see some analysts who are great at what they do researching say, Facebook, and even if they are not overly optimistic, they can point to growth in usage and users and draw positive conclusions on that, which the potential investor might point to as basis for his own analysis. Meanwhile the analyst would never, ever buy Facebook personally!

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JT McGee December 14, 2012 at 14:07

Yeah if you’re any good then you won’t be working as a sellside analyst for very long. Typical move is from sell-side to buy side analyst with the eventual end game being a position in portfolio management. I mean, if you’re that good, your picks are better used by a fund than by a broker looking to generate commissions.

It’s hard to trust people who cannot say “I don’t know.” If someone has to have an answer for everything, I’m not so sure I’d be that confident in what they have to say.

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Darwin's Money December 15, 2012 at 19:18

I don’t pay any attention to analysts these days. Is there any data out there to show a winning strategy of following analysts’ recommendations? Either individual analysts or in aggregate? I’d be surprised if it showed anything more than random probability. The way they get paid, you’d think they matter. They do move markets. But it’s often too late to act on their call since the market reacts immediately to their calls rendering them even more worthless to the typical retail investor.

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JT December 16, 2012 at 15:07

The analyst information that the public sees is from the sell side, the people who make money by generating fees and commissions. They’re hired to increase turnover and activity, and hopefully generate winning calls for their firm’s clients. Obviously there is a disconnect here because the firm makes money on the commission, not necessarily the investor’s performance.

Not aware of any study tracking analysts. If an analyst turns out to be a rockstar, his or her research won’t be public for very long. Why pay someone to generate marginal amounts of commission by beating the market when you can have them on your research desk managing a bunch of money for you, not your clients?

You might find this interesting. Most of the world’s most successful investors all share the same common roots.

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