When investors have questions, who do they call?
When you have health-related questions, you may look to a doctor for advice. You expect that medical professionals are up-to-date with the latest information in their specialties by continuously doing research. Thus, they’re theoretically able to provide you with the best answers to your concerns. Similarly, when investors have stock-related questions, they may look to an equity research analyst to provide them with detailed advice.
Analysts provide investors with analysis of companies
Equity research analysts study companies and their stocks to provide buy, sell, and hold recommendations. In industry jargon, we say they “cover” a particular set of stocks. Some analysts publish their recommendations to their clients, such as those who work for investment banks, wealth management companies, or independent research firms. There are also analysts that perform this research solely as part of the portfolio management process at an asset management company, such as at a mutual fund or hedge fund.
Recommendations include a variety of information
There are many factors that analysts consider when making their recommendations. They might look at industry-level information such as market growth trends, competition, new technologies, etc. Company-specific factors include profitability, product trends, the management team, the quality of the company’s governance structure, the company’s financial statements, and more. Altogether, we often refer to this as “mosaic theory,” which means the analyst puts together a mosaic of information from a variety of sources.
It’s important to look at the whole picture
Just as importantly, analysts also consider the price and value of the stock itself. This is because it’s possible that a good company doesn’t make a good investment. For instance, the stock may be over-priced relative to what the analyst believes the company’s earnings may support, even if that company has popular and profitable products. Similarly, even a company with less-than-stellar prospects may make a good investment if its stock is inexpensive enough.
Ratings can be relative
When an equity research analyst is providing a recommendation, it’s also necessary to understand to what the analyst is comparing the stock. For example, one analyst might cover online retailers relative to all retail companies. Another analyst might cover similar stocks but compare them to internet companies. Thus, when looking at an analyst’s rating, it’s important to understand the relative nature of the rating..
Your portfolio matters when choosing stocks
Ultimately, analyst ratings can be helpful when studying individual stocks and companies. However, it’s important to consider a variety of sources and opinions. It’s also important to remember that their predictions are hypotheses based on research, and just because an analyst gives a particular recommendation doesn't mean it’s entirely accurate. In addition, considering how a stock fits into your portfolio can be just as important as how the stock is rated.