Stock ratings: How dependable?

Here is an extended more comprehensive article on investment house ratings and what it means !

Benjamin Graham says, '...in the short term, the market is a 'voting' machine whereon countless individuals register choices that are product partly of reason and partly of emotion. However, in the long-term, the market is a 'weighing' machine on which the value of each issue (business) is recorded by an exact and impersonal mechanism.'

It has always proved to be a challenge when it comes to determining the ‘right’ price of a stock. The complication arises because stock prices are not only a factor of historical track record of a company, but also ‘expected’ earnings growth in the future. But when it comes to ‘expectations’, there is a great deal of analysis involved (subjective and quantitative). Economic growth projections of various research agencies are one classic example.

Expectations vary person and person (individual investors, research houses, institutional investors, technical analyst, traders and so on) and this is what makes the stock market very interesting and at times, complicated. Given the complexities involved, how do individual investors take investment decisions?

Apart from a few set of investor who depend on their own assessment, investment decisions are taken based on what brokerages/research houses recommend. The recommendation could be a broader sectoral view (i.e. whether the cement sector looks promising) or what should an investor do about a stock (say, Tisco)?

Therein lies another complication. There are no universal standards when it comes to stock recommendations. While some brokerages follow the traditional Buy-Sell way, there are some who recommend stocks with an Overweight-Underweight-Neutral strategy. In this article, we try and simplify some of these ratings for You, the individual investor! But one extremely critical factor that we have not focused on is the rationale behind these recommendations, which needs utmost questioning. We limit ourselves to only the ratings part in this article.

Buy – Sell – Hold

Generally, a stock is recommended a Buy when it is expected to give a return, say around 15% per annum and a Sell if the upside from the date of recommendation is, say less than 10%. Hold is generally for those stocks, which have been already recommended by the brokerage. But again, the standards are not common for all.

Out-performer – Under performer – Market performer

In the institutional and the fund management side of the equity market, what is more important is the relative performance to the benchmark index. Simply put, if a Fund X benchmarks itself against the BSE Sensex, the fund manager focuses on bettering the index (i.e. Rs 100 in his fund should yield more than Rs 100 invested in the BSE Sensex). The rationale is simple. Why would an investor buy the Fund X (with a entry or exit load) when it is expected to perform like the BSE Sensex (index funds usually charge lower load as compared to let’s say, a diversified fund)?

So, if a brokerage puts out a Out-performer rating on a stock, generally, the stock is expected to outperform the benchmark index by around 10%-15% (varies across the board). Here, one critical factor needs to be understood. If a brokerage expects the stock market to fall by say 10% and recommends an out-performer rating on a stock, even if the stock falls by 5% in the similar period, it has still out-performed the index!

Under-performer is recommended when the stock is expected to appreciate/depreciate lower than the benchmark index and Market performer is one where a stock is likely to track the index performance. In these kinds of recommendations, the view on the stock is as important as the view on the stock market as a whole.

Overweight – Underweight – Equal Weight

Sounds like a report card from a weighing machine in the local railway station! This is actually a fund management strategy. In order to outperform the benchmark index, the fund house needs to a different stance as compared to the market. In the BSE 30 for instance, if the software sector has a 15% weightage (i.e. the combined market capitalisation of software stocks in the BSE 30 divided by the total BSE-30 market capitalisation) and if a brokerage is overweight on this sector (more positive), the sum invested in software stocks could be higher than the overall benchmark index. Thus, it expects to outperform the benchmark index.

In the 2000 tech boom, a number of funds were overweight on software stocks only realising later that weight loss is the only way out of the mess! From an individual investor perspective, a whole host of factors needs to be understood and we suggest not following such a strategy. Individual investor’s risk-return profile and a risk-return profile of a group of investors (which is what a mutual fund is) are different in most cases.

Attractive – In-line – Cautious

Mostly, these recommendations are sectoral or for the economy as a whole. If a brokerage believes that the cement sector looks good from a long-term perspective and the stocks are likely to outperform the broader benchmark (say the BSE Sensex), it recommends an Attractive rating. If it is not, then it takes a cautious stand. Since these recommendations also involve relative benchmarks, from an individual investor perspective, the complications increase.

Common sense matters the most…

Before you take an investment decision based on the news of a recommendation by a brokerage, it is important to understand one’s own risk-return profile i.e. how much am I willing to forgo? This will determine your rating and the investment style.

The word ‘strategy’ sounds exciting but has its own limitations. There have been instances of a brokerage changing its rating style each year in the past. If you have a copy of a research report, we suggest you to read the finer print. If you do not have a copy (most of the times, inaccessible to individual investors), atleast understand the rationale behind the recommendation. One day here and there will not make a much difference to the final outcome of the investment decision, if one is looking to build a viable portfolio of investments that is dividend paying and gives capital appreciation along the way. Following the herd is not the sure shot way of improving one’s own financial rating!