Buy, Hold, and Sell Ratings

Buy, Hold, and Sell ratings (also known as 'analyst ratings' or 'stock ratings') are recommendations published by financial analysts—typically sell-side analysts working for large investment banks and brokerage firms. In theory, these ratings provide a simple, digestible forecast of a stock's likely performance over the next 12 to 18 months. The rating is the headline of a more detailed equity research report, which usually includes a price target—the specific price the analyst believes the stock will reach. While they seem helpful, a savvy investor, particularly one following the value investing philosophy, views these ratings with a healthy dose of skepticism. The financial industry is riddled with conflicts of interest, and analyst ratings are a prime example. An overwhelming majority of ratings are “Buy,” while “Sell” ratings are as rare as a humble CEO on an earnings call. This optimistic bias is a major red flag and underscores why you should never make an investment decision based on a rating alone. Instead, they are best used as a starting point for your own diligent research.

While the language can vary slightly between firms, the ratings boil down to three main signals. Understanding the lingo—and the subtext—is the first step.

• Buy (or Strong Buy, Outperform, Overweight): This is the most common rating. The analyst believes the company's stock will produce a better return than the overall market or its industry peers over the next year. It's a thumbs-up, signaling that the analyst is bullish on the company's prospects.
• Hold (or Neutral, Market Perform, Equal Weight): This rating suggests the stock is expected to perform in line with the market. It's neither a strong endorsement nor a condemnation. However, many seasoned investors interpret a “Hold” as a polite “Sell.” Given the pressure on analysts to maintain positive relationships with the companies they cover, downgrading a stock to “Hold” is often as negative as they're willing to get.
• Sell (or Strong Sell, Underperform, Underweight): This is the rarest and boldest of calls. An analyst issuing a “Sell” rating expects the stock to perform significantly worse than the market. Because this can damage the relationship between the analyst's firm and the rated company, a “Sell” rating often implies that the analyst has uncovered a very serious problem.

For a value investor, whose goal is to buy wonderful companies at a fair price, analyst ratings are largely noise. The philosophy of Warren Buffett and his mentor Benjamin Graham teaches us to focus on a business's long-term intrinsic value, not short-term market predictions.

Sell-side analysts are not objective academics. They work for firms that often have lucrative investment banking relationships with the very companies they are “analyzing.” These banks manage IPOs, advise on mergers, and provide other fee-generating services. A negative rating can jeopardize these multi-million dollar deals. Is it any surprise, then, that a 2018 study found that “Sell” ratings made up only 6% of all recommendations from Wall Street analysts? This conflict creates an institutional pressure to be optimistic, which is poison for an investor seeking an unbiased opinion.

Analyst ratings are almost always tied to a 12-month price target. This short-term horse-race mentality is the polar opposite of the value investing approach. A value investor thinks like a business owner, focusing on a company's durable competitive advantages, its management quality, and its long-term earnings power. Whether the stock hits a certain price in 12 months is largely irrelevant. The key questions are: What is this business worth? And can I buy it with a sufficient margin of safety? Analyst ratings rarely, if ever, answer these fundamental questions.

A little cynicism can be a powerful tool. Here's how a practical investor might translate these ratings:

• Buy: “Our firm likes this company, and we think the stock might go up. Please read our report to see why we think that, and then do your own homework.”
• Hold: “We can't say 'Buy' with a straight face, but we don't have the courage to say 'Sell' and risk angering the company's management. You should probably look for better opportunities elsewhere.”
• Sell: “Wow, we are really concerned. Something is fundamentally broken here, and we're willing to burn a bridge to say so. This is worth investigating immediately.”

So, should you ignore them completely? Not necessarily. While they are terrible as a simple “buy/sell” signal, they can be a useful tool if used correctly.

Ratings can be a jumping-off point for research. A sudden wave of downgrades on a previously loved stock could signal an opportunity for a contrarian investor to investigate if the market has overreacted. Conversely, a lone analyst upgrading a stock that everyone else hates might have spotted something the herd has missed. Use these signals not as answers, but as interesting questions that prompt your own investigation.

The real value isn't the one-word rating; it's in the full research report behind it. Ignore the headline and read the thesis. A good report will detail the analyst's assumptions about the company's future revenue growth, profit margins, and cash flow. You can then challenge these assumptions:

• Do you believe their forecast for earnings per share is realistic?
• Have they properly accounted for competitive threats?
• Are their projections for free cash flow based on solid evidence or wishful thinking?

By critiquing the analyst's work, you sharpen your own thinking and get closer to determining the true value of the business. In the end, analyst ratings are just one of many inputs. Your most trusted analyst should always be yourself.