Have you ever seen a stock you own rise or fall in material fashion even though there's been no news from the company? Often, the driving force in such a situation is a report from a Wall Street analyst. A buy rating can lead to gains while a sell rating (or even a downgrade from a "buy" to "neutral") usually results in a sell-off.
Here's what you should do when you come across this situation in your portfolio.
Analyst opinions aren't necessarily better than yours
The most important thing to remember when you see an upgrade or a downgrade is, it's just another piece of information. You don't have to do anything at all because of it.
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Wall Street analysts are usually highly educated, and they spend a great deal of time perfecting their craft. And what they think is, as you would expect, grounded in facts. Yet, the truth is, the best they can offer is an educated guess because the future is inherently unknowable. That remains true even if they know a company better than you do.
For example, at the time of this writing, food maker Hormel (HRL 0.14%) has one strong buy, one buy, eight holds, one underperform, and no strong sells. Which of the 11 analysts is right? Only the uncertain future will reveal that fact.
But here's where things get interesting. Just a month earlier, the ratings breakdown was seven holds and four underperforms. There's a clear shift in the sentiment here, with analysts getting generally more upbeat. Two analysts shifted from hold to some form of buy and another three moved up from underperform ratings between July and August. This is where the real value starts to come in for investors -- why are analysts changing their minds?
The buy/sell logic might matter
You shouldn't necessarily ignore analyst ratings changes (though it would probably be just fine if you did). Presumably, you bought the stocks you own for a reason. If you had done your due diligence, you've most likely written your logic down so you can refer back to it and periodically test your hypothesis. The best thing you can probably do with an analyst upgrade or downgrade is try to understand why the change has been made, and pit that against your own investment thesis.
For example, you may own a company like Hormel because the business is performing relatively poorly and worried investors have pushed the stock price lower and the dividend yield toward historical highs. You might think it is cheap, noting that the company is a highly elite Dividend King, suggesting it has successfully muddled through business downturns before.
You might believe that buying an out-of-favor company that has increased its dividend at an annualized rate of more than 10% over the past decade seems like an attractive proposition. And your plan could be to hold on to the stock until, well, you can pass it on to your heirs, collecting the fast-growing dividend all along the way.
At the end of the day, this is an educated guess on your part and is likely no better or worse than what an analyst might have to offer. The future performance of the business is what will prove you are right or wrong. Analyst upgrades and downgrades, meanwhile, can be pitted against that thesis. From a big picture point of view, the fact that analysts are getting generally more positive supports the idea that Hormel is successfully muddling through this tough patch just like it has previous ones.
But what about getting even more specific? If you have the benefit of seeing the logic behind an individual analyst rating change, you have a comparison point against which to challenge your specific thesis. Investing is hard and for individual investors, it is often a solitary effort. Having the benefit of another opinion, even if you don't agree with it, is valuable because it may result in you thinking about something differently.
It is human nature to focus only on facts that support our personal beliefs. That's a bad habit when it comes to investing, because you may be ignoring bad news. Analyst ratings changes can help you broaden your scope, bringing in information that may contradict your opinion. That may not lead you to change your view, but at least you'll have to integrate the new information and decide whether or not it has meaning.
A caveat to keep in mind
There's one piece here that's probably important to highlight, however. Analysts often have shorter time horizons for their outlooks, perhaps as little as 6- to 12-months. You'll need to keep this in mind if your intended holding period is in years, or decades.
For example, an analyst might spend a lot of time thinking about the impact of the avian flu on Hormel's Jennie-O turkey business. Or the new product launches in the recently acquired Planters business. They might even model out the impact of such changes on revenue and earnings. Over the next year, these are likely to be important factors to think about and it is good that you do consider them. If analyst actions help you keep on top of such facts, you'll be better off for taking the time to read and understand the analyst's decision.
But over the longer term, avian flu, or a specific product launch or two aren't likely to be the main driving factors of the company's performance, or stock returns. For example, avian flu waxes and wanes over time. If history is any guide, its importance will eventually recede (and it will probably pop up again in the future). As for product launches, a single win or loss on this front is less important than the fact that Hormel keeps innovating, which has historically been one of the company's most attractive attributes. A quick update on these facets of the business is valuable, but only if you keep the impact in the proper context.
It's just information. Use it to your advantage.
At the end of the day, analyst upgrades and downgrades are really just information. Buying and selling because some analyst said so isn't a rational approach. You'll probably be perfectly fine if you don't pay any attention to them, but if you do, the best thing is to compare the analyst's logic to your own logic. Maybe there's some nugget of value. You can take in that incremental information and then happily stick to your own long-term investment plan.
