If you open the research report on companies by any reputed broker you will find analyst recommendations or classifications like Strong Buy, Buy and Sell etc. This is part of the stock grading system that brokers and analysts follow. While there is no hard and fast rule to define each of these categories, there are some broad consensus definitions that can outline each of these grades. As an investor you need to understand how are stocks rated and what the stock analyst ratings actually mean? Broadly there are 3 categories of grading of stocks that are based on investment recommendations, relative index performance and benchmark weights. Let us understand the broad divisions and the sub-categories in detail..
What so we understand by Grading based on recommendations..?
Different brokers and analysts use different words but broadly, you will find 6 sub-categories of grades that are assigned to stocks. Let us look at these grades in detail..
Strong Buy: Normally a strong buy is a stock that the analyst expects to give a return of over 25% in the next 1 year. Such stocks have fundamental story and momentum in their favour. Strong buys are not only defined in terms of absolute returns but also in terms of relative returns. For example, a strong buy can also be a stock that can outperform the index by more than 10% in the next 1 year.
Buy: Slightly below the strong buy category is the Buy category. Here in absolute terms the analyst or the broker refers to likely returns of around 15-20% in the next 1 year. In relative terms, this category is expected to outperform the market index by around 5% in the next 1 year.
Accumulate: Some brokers refer to this category as accumulate while others refer to this as Add. It typically refers to stocks that are likely to earn about 10% returns in the next one year or approximately equal to the index returns. Accumulate recommendation refers to stocks that may not have immediate visibility but has the potential to substantially outperform in the next 3-4 years. It is a stock that calls for patience in investing.
Neutral: Neutral is normally used to refer to a stock that has decent upside potential but that comes with downside risk too. For example, a stock in the Neutral category may have a 15-16% upside potential in the next 1 year. But the risk parameters may be such that the stock may also end up 10% lower in the next one year. That is why the analyst is slightly more circumspect about such stocks.
Reduce: This is a stock where there is a clear negative view and more likely this is specific to that particular stock. A Reduce call is given when the view on the stock is a negative return of 10-15% in the next 1 year
Sell: In case of stocks that are categorized as Sell, there is a company level negativity and also a structural sectoral negativity. Normally, stocks that are classified as Sell have the potential to correct by 20-25% in the next 1 year.
Grading based on index performance
When you are judging a stock in absolute terms and then grading the stock it is purely performance based. The second approach is more relative and it measures or evaluates the performance of the stock with respect to an index. It could be a broad-based index like the Nifty or a sectoral index, as the case may be.
Market outperformer: A market outperformer is a stock that is expected to better the index returns by at least a margin of 3-4% over the next 1 year. To be more realistic, the returns of the index in this case are calculated on the basis of the Total Returns Index (TRI) which includes the impact of dividends also.
Market performer: A market performer is a stock that is likely to give returns at par with the index with a margin of 1-2% on both sides. Normally a market performer is not preferred unless there is a strong long term story. Otherwise you are better off with an index fund.
Market underperformer: A market underperformer is a stock that is likely to give positive returns but may give you less than the index. That does not make sense buying as per the CAPM which expects stocks to return higher than the index. Normally, such stocks earn 3-4% lower than the index returns.
Grading based on benchmark weights
The grading based on benchmark weights does not get into outperformance or underperformance or return expectations. It purely looks at the stock based on which it deserves an overweight or an underweight with respect to a model portfolio.
Overweight: A stock is an overweight if the weight assigned to the stock in the portfolio is more than the weight assigned by the model portfolio. These are normally stocks that have the potential to generate alpha in the coming months.
Equal Weight: An equal weight is a stock on which you are broadly neutral with respect to the index and you prefer to maintain the same weight on the stock as in the model portfolio.
Underweight: Finally, an underweight is a stock that deserves a lower weight than given in the model portfolio. Obviously, when you go overweight on the winners, you need to go underweight on the potential losers.