Of the myriad of factors that can move the share price of a stock, analysts ratings are among the “easier” to understand. When a respected firm upgrades or downgrades equity, the effects often quickly leak into the market. In March, after Stifel downgraded GrubHub’s stock from buy to hold, the stock fell 2.1% in pre-market trading. In the same month, a prominent Stifel analyst also downgraded Netflix from buy to hold. Netflix shares fell 1.3% the following day (Note: the market as a whole was down that day).
Sophisticated investors may interpret these types of downgrades as lower price targets (which they are) given the decline in bullishness from analysts. But what about the Main Street investor who interprets these ratings at face value — as literal buy and hold recommendations? If we apply a little logic to the concept of a hold rating, a fair amount of ambiguity emerges.
Let’s use the example of Netflix’s downgrade. Imagine that you hold shares of Netflix, but I do not. Before the Stifel downgrade, if we interpret the ratings at face value, I should buy Netflix shares given their buy rating, and you should either buy more or hold and reap the benefits of satisfaction via the confirmation bias attributed to the buy rating. But let’s assume my trade doesn’t go through and now Netflix has been downgraded from buy to hold. At face value, I’m not supposed to buy, but you’re supposed to keep. Unless trading costs are very significant, this violates transitivity.
A stock can only go up, down, or stay constant. If we ignore diversification strategy for a moment, you should just hold equities you think will go up — you lose money on stocks that go down, and you’re better off holding cash than shares that remain constant. If this is the case, if you’re holding Netflix, that should imply you think it will go up, so shouldn’t I be in the position to buy? The only difference between owning stock through buying and holding is the cost of trading, and if trading costs are insignificant, preference over buying and holding should be indifferent. The hold rating seems to assume some illusionary value to the endowment of a stock. If we want to refrain from honoring sunk costs, one’s investment behavior towards a stock shouldn’t depend on whether they already hold that stock or not.
It’s like if we’re both in line at the movie theatre (with a cost-free ticket return policy) and following hypothetical real-time reviews from Rotten Tomatoes. The surveys indicate that we should see the movie (i.e., buy rating), so you buy a ticket. As I’m about to buy my ticket, the reviews change to “hold,” implying that you should hold your ticket, but I shouldn’t buy. This makes no sense given the cost-free return policy — what difference should it make if you already bought the ticket?
What Do The Firms Say About A Hold Rating Definition?
This may seem like an argument over the proper use of syntax among different ratings, so let’s look at what these firms define their scores as. A guide to analyst ratings provided by MarketWatch offers insight into the meaning behind particular ratings from various firms. Let’s look at a few of these firm definitions for hold ratings, including Stifel Nicolaus whose hold rating is called “Market Perform”:
Stifel Nicolaus: “Stock is expected to perform generally in line with the S&P 500 over the next 12-18 months and is potentially a source of funds for investor clients.”
Jefferies & Co.: “Expected to change plus or minus 10%. Stock’s total return is expected to be in line with the average total return of the analyst’s industry coverage universe, on a risk-adjusted basis, over the next 12 months.”
Baird: “Expected to perform in line with the broader U.S. equity market over the next 12 months.”
Wells Fargo: “Holding the stock is recommended. The stock has moved out of preferred buying range, but there is further upside to share price or stated objectives at the time of purchase have changed, and share appreciation may take another 6-12 months.”
A deeper dive into the definitions of a hold rating indicates that most firms define a hold as a stock that will either perform in line with the market or return +/- 10%. A more bombastic way of interpreting these ratings is that they are an analyst’s way of saying, “I’m not really sure.” Plus or minus 10% or “in line with the index” is the equivalent of the sports pundit saying the team who “comes to play” will win. Further, if a single share is expected to perform the same as the overall market, wouldn’t an investor be better off holding the index itself rather than one particular stock?
What does all this mean? While upgrades and downgrades still imply a change in sentiment, perhaps it may be wise for Main Street investors to interpret the hold rating as more of a signal of ambiguity rather than the literal definition of a hold.