I have been watching stocks for nearly 30 years now, many terms like ‘overweight’ still can be confusing to investors like me. So it is very natural for many investors to not fully understand terms like this. Many investors may even think that that investment analysts conjure up fancy terms in their lingo just to confuse the ordinary investors, instead of a simple and actionable ‘buy,’ ‘sell,’ and ‘hold/ stay’ trinary.
Take ‘overweight’ for example, a term pretty regularly used by many analysts. Or its inverse ‘underweight.’ Of course, the ordinary investor is smart enough to not get defensive about her own waist size each time she reads investment advice columns and encounters ‘overweight.’
What does the overweight stock rating mean? The short answer is that it a positive rating that indicates an excess to the benchmark or portfolio. Unfortunately, the term so commonly used by investment analysts and does not a crystal clear definition and may slightly different meanings in different contexts. That being said, some common systems have evolved over the years to which most recommendations are confined, the three-tier and five-tier ones being the most commonly used.
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The Overweight Rating Scale Explained
An analyst using the three-tier scale might summarize his recommendation in one of these three actions: ‘Buy’, ‘Hold’ and ‘Sell’.
On a five-tier scale, two additional levels will be snuggled in, usually on either side of ‘Hold’ before the ‘Buy’ or ‘Sell’ recommendation is reached, indicating a slightly lower than a ringing endorsement for that action. Thus, ‘overweight’ in most five-tier recommendation scales can be considered to be a ‘buy’ recommendation but a little less enthusiastic than a ‘buy’ rating.
Similarly, ‘underweight’ in most recommendation scales can be considered to be a ‘sell’ recommendation but a little less enthusiastic than a ‘sell’ rating on a five-tier scale.
Many analysts do not use ‘overweight,’ relying on ‘outperform,’ ‘add’ and ‘accumulate’ instead, and ‘underperform,’ reduce’ and ‘weak-hold on the sell-side.
But, how does it work if the analyst uses a three-tier scale?
Good question. In such a scenario, ‘underweight,’ ‘equal weight’ and ‘overweight’ is perhaps the most common classification, where ‘overweight’ is as close to a ‘buy’ recommendation as the firm is comfortable in issuing.
The Relevance of Weight
To make matters more confusing, the weight analogy is used in other situations as well.
Many an analyst and broker rely on a balanced portfolio being the bedrock of an investment strategy. When an investor does not have a balanced portfolio, it means she has too much of one stock or type of stock in her portfolio since too little in a portfolio is the stable state, there being thousands of options to choose from; she will always be underweight on thousands of stock she does not have in her portfolio.
Below is a great video by Jim Creamer using “overweight” in a stock sector movement.
Being heavily exposed to one stock or type is also called being ‘overweight’ in it.
This use of ‘weight’ is also perhaps similar to its meaning in the classical sense of the language.
Indexes, such as the S&P 500, are also based on the market capitalization of stocks and typically define its ‘weight’ in the index. Apple had a 5.74% weight in the S&P 500 in July 2020 because of its market capitalization at that time.
By rating a stock as ‘overweight’ the analyst is also saying that the stock deserves a higher weight in the index that it is a part of, on the basis of future performance which is likely to increase its market capitalization in relative terms to other stocks.
‘Underweight’ and ‘overweight’ can be used in reference to not only individual stocks, but sectors as well. An analyst could recommend that Retail is overweight which means that he expects better performance from Retail stocks relative to stocks of other sectors.
An Investment Analyst – Where does He Fit in?
There being thousands of stocks to choose from, it is easy to understand that it is not possible for each investor to follow the advice of gurus and research the fundamentals of a stock before making decisions. Most researchers rely on one or more investment analysts, also called stock analysts or research analysts, for their investment-related decisions. In general, analyst recommendations are understood to be relevant for a 6 to 12-month time horizon.
While analysts do issue detailed reports on the stocks they study, even these may be too voluminous for many investors to either study and/ or understand. Most look for the ‘bottomline’ recommendation of the analysts.
Take Overweight Rating Ratings with a Pinch of Salt
In simple terms, by rating a stock as ‘overweight,’ an analyst is suggesting that it is expected to perform better than other competing options available to investors and should be taken as a suggestion to buy the stock.
However, we all know that nobody can see the future. An analyst is only another human being who provides recommendations based on information in his possession and his analysis of it. Many analysts differ in their outlooks on the same stock. Besides, all recommendations are issued with a lot of caveats and disclaimers.
As an investor, an analyst’s recommendation should be taken for what it is, an additional piece of information in the puzzle that constitutes investing. It is not gospel. There are no guarantees.