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As you'd probably guess, one of the many "perks" of my job is getting to read a lot of Wall Street research reports. And I'll let you in on a little secret...
They are rarely entertaining.
These reports are usually published to provide the most up-to-date numbers and data, and the actual writing seems to be only an afterthought. However, they're not all bland. Just a few days ago, one report caught my attention with this interesting opening line:
"Here's an observation that won't shake many worldviews: analyst ratings exhibit bias."
I've long been skeptical of analyst ratings that assign a "buy," "sell" or "hold" ranking to different stocks. In talking with analysts, I've learned that some believe the most important aspect of their job is to facilitate discussions between clients and management. For example, if a trader at a large hedge fund asks for a phone call with the CFO of a certain publicly traded company, the analyst will do their best to introduce the two.
This serves two purposes: First, this shows the hedge fund client that the analyst is worth knowing, and the client is then likely to reward the analyst's firm with business. Second, this shows the CFO that the analyst has influence, something that executive will hopefully remember the next time she is looking at issuing debt or securing short-term financing.
Introducing two people has nothing to do with an analyst's research into a stock or company, yet many analysts consider it to be important to their job. If you ask me, it seems like some serious conflict of interest is built into the system.
Going back to our example, if our analyst starts to say that the company's stock should be sold, it's possible the CFO might stop taking the analyst's calls. Suddenly, the analyst might not be able to meet a potential client's request to set up a meeting with high-level executives. Overall, it lowers the analyst's value to his firm.
Now, I'll admit that I can be a little cynical at times. However, I firmly believe that no one on Wall Street is going to do something that makes them less valuable. In an industry focused on value, all analysts are trying to maximize their personal value.
That's why I wasn't at all surprised to learn that, as of the end of October, there were no stocks in the S&P 500 with a consensus "sell" rating. Instead of saying "sell," an analyst is more likely to rank a stock as "hold."
In fact, "sell" ratings have become downright rare. According to the FactSet report, over the past 10 years, only 0.3% of S&P 500 stocks had either a "sell" or "underweight" rating in any given month.
Today, analysts generally use just three ratings -- "buy," "overweight" (basically another way to say "buy") and "hold."
So, if analysts are weary to rate anything as a "sell," does that mean "hold" is the new "sell" ranking?
The answer, at least according to the FactSet report, is no.
"Sell" (and the similar "underweight") is still the best indicator that a stock will underperform the broader market by a wide margin. While these two ratings are rare, they do tend to be accurate: The FactSet backtests showed that, over the past 10 years, stocks ranked as "sell" or "underweight" returned (respectively) 57.2 and 98.9 percentage points less than the S&P 500.
The backtests also showed that, as a group, stocks ranked "hold" actually performed the best, followed by "overweight" stocks, and then finally the "buys," which underperformed the S&P 500 by 13.3% as a group.
So, if the three most common analyst rankings -- "buy," "overweight" and "hold" -- don't necessarily correspond to whether we should actually buy, hold or sell a certain stock... why should we bother looking at analyst ratings at all?
Based on FactSet's findings, there are a few key things we can still take away from analyst rankings:
1. "Sell" (and "underweight)" truly means sell.
Like I mentioned earlier, the data found that stocks with "sell" and "underweight" ratings vastly underperformed the broader market. That means a great strategy would be buying puts on stocks with either of these ratings. As the stock's price fell, the value of the put option would go up, which you could then sell for a profit. Unfortunately, because these ratings are so rare, you probably wouldn't be able to make many trades following this strategy.
2. "Hold" at least means hold, but can also mean buy.
FactSet's backtests showed that, as a group, stocks rated "hold" were actually the best performers, which is information we can directly apply to our put selling strategy.
You see, the most effective way to use my put selling strategy is to sell put options on stocks that are either going to stay near their current prices or even go up in value. If the underlying stock's price remains above our strike price through expiration, our puts will expire worthless, which means we'll get to keep 100% of the premium we received as pure profit.
Even if the stock falters and we're assigned shares at a "value" price, a stock that outperforms should see its price increase over time, allowing us to eventually sell our shares for a profit (and collect more income from selling call options while we wait).
To find stocks that meet the needs of our put selling strategy, we should look for the ones that have a large number of analyst "hold" ratings.
[Editor's note: If you're not familiar with selling put options, I suggest you check out this special presentation Amber put together to explain just how her strategy works. In it, you'll learn more about Amber and how she started selling put options to supplement her military income... what put options are and exactly how they work... the special indicator she created to to find the best put selling opportunities available right now... and exactly how much extra income her subscribers pull in each week. Click here to go to her webinar.]
Heading into the end of the year, we often see rallies in the stock market. And the stocks likely to benefit are the ones that offer value, like this company.