Understanding Underweight Stock Recommendations: What They Mean

When a market analyst designates a stockStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably. or security as an underweight recommendation, he or she is stating their belief that the stock will likely underperform compared to some benchmark stock, security, or index. Therefore, investors should devote a smaller percentage of their investment portfolio to holdings in that stock. An underweight recommendation does not mean that a stock or security is necessarily bad, and a stock or security labeled underweight by one analyst may be labeled overweight or equal weight by another analyst.

Alternatively, the term “underweight” can also be used to refer to a portfolioCapital Allocation Line (CAL) and Optimal PortfolioStep by step guide to constructing the portfolio frontier and capital allocation line (CAL). The Capital Allocation Line (CAL) is a line that graphically depicts the risk-and-reward profile of risky assets, and can be used to find the optimal portfolio. that does not hold sufficient amounts of a particular stock or security in relation to a benchmark portfolio or index. For example, if the benchmark portfolio holds security XYZ with a weight of 10% and an investor’s portfolio only owned 5% by weight in their portfolio of security XYZ, then the investor’s portfolio would be deemed as being underweight in security XYZ as compared to the benchmark.

Underweight Recommendation – A Brief Explanation

Most market indices such as the Dow Jones Industrial Average (DJIA), NASDAQ Composite, and the Standard & Poor’s 500 Index (S&P 500) assume that each component stock in the index should be assigned a proper weight in order to construct an index that accurately reflects the performance of the overall market. However, the weighting systems used by various indices are not uniform or consistent and, in fact, differ substantially.

For example, the Dow Jones Industrial Average uses a simple average based on share prices, making it a “price-weighted” index, and only includes 30 stocks, whereas the components of the S&P 500 Index, which includes 500 stocks, are weighted by market capitalizationMarket CapitalizationMarket Capitalization (Market Cap) is the most recent market value of a company’s outstanding shares. Market Cap is equal to the current share price multiplied by the number of shares outstanding. The investing community often uses the market capitalization value to rank companies.

Thus, a stock or security can be considered underweight when compared to one benchmark but considered equal weight or overweight when compared to a different benchmark. For example, the S&P 500 favors large companies with large market capitalization and gives more weight to such stocks.

Consider the following example. A financial services company issues an underweight recommendation for stock A and an overweight recommendation for stock B. An investor knows that the financial services company uses the DJIA as its benchmark index. The investor then sees that the market capitalization of stock A is five times greater than the market capitalization of stock B – a fact not reflected by the Dow Jones Industrial Average. In this case, despite an underweight recommendation, a lower number of shares of stock A may be more profitable than holding a greater number of shares of stock B.

Underweight Recommendations for the Prospective Investor

Unfortunately, most financial services companies (the ones issuing the underweight, equal weight, or overweight recommendations) do not disclose the degree to which an “underweight” stock is underweight (or an overweight stock is overweight). This causes a problem for prospective investors who are trying to decide how to allocate their investment capital between two underweight stocks or two overweight stocks, solely based on a market analyst’s recommendation. This often leads to investors completely avoiding all stocks with an underweight recommendation. Such a trading strategy is clearly suboptimalCapital Allocation Line (CAL) and Optimal PortfolioStep by step guide to constructing the portfolio frontier and capital allocation line (CAL). The Capital Allocation Line (CAL) is a line that graphically depicts the risk-and-reward profile of risky assets, and can be used to find the optimal portfolio. and can result in severe underperformance should the recommendation issued prove to be bad advice.

Moreover, financial services companies, as well as analysts, differ in their time frames when issuing recommendations. A long-term investor looking to maximize profits over a long period of time may be willing to hold stocks that generate lower than average returns in the short term, in order to avoid paying higher tax rates and additional transaction fees.

Investors should not take underweight ratings too literally. Instead, they should merely see them as what they are – the subjective opinion of a market analyst who believes that the stock is not as attractive as others. Whether an investor chooses to agree with the recommendation may depend on several factors, such as the following:

1. Whether the investor and the analyst issuing the recommendation have the same investment ideology and goals.
2. Whether the investor and the analyst are making decisions based on the same time horizon.
3. Most importantly, whether the investor believes the analyst issuing the recommendation is correct.

Conclusion

Unfortunately, there is no mathematical formula or program that can tell an investor if a market analyst’s recommendation is correct. It has often been the case that the same financial services company issuing recommendations for the same stock have made a correct recommendation during a particular month and an incorrect recommendation regarding the stock during another month.

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