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.
I found that six months after the downgrade, the valuation-downgraded stocks had averaged a 20 percent return (price changes plus dividends), double the S&P 500's 10 percent return over the same period. By comparison, a second group of stocks downgraded for reasons other than valuation, averaged a seven percent 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 published here almost 12 years ago (October 30, 2005) when I found that, over a six month period, 11 valuation-downgraded stocks averaged a 12 percent return vs. three percent for the S&P 500.
Both of my test portfolios included only stocks downgraded to "hold" or "sell" during September 2016. Many analysts are reluctant to rate any stocks at "sell" so they use "hold" instead. Thus, for all practical purposes, "hold" and "sell" mean the same thing. Same thing for synonyms like "neutral," "market perform, "underweight," "sector perform" or "underperform."
I picked September for two reasons: 1) it was six months back, a reasonable time frame 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 "Overvalued" Stocks 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 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 forecasts. The higher target prices, of course, allow analysts to up their ratings back up to "buy," which typically moves trading prices higher.
Here are five stocks that were recently downgraded to "hold" or "sell" based primarily on valuation: Chipotle Mexican Grill (NYSE:CMG), Nu Skin Enterprises (NYSE:NUS), O'Reilly Automotive (NASDAQ:ORLY), Varex Imaging (NASDAQ:VREX) and Wix.com (NASDAQ:WIX).
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.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.