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Putting an underweight rating on a stock is the way that Wall Street analysts express their opinion that the stock has a below-average chance of matching the performance of an appropriate major stock market benchmark. The underweight rating indicates that there are not enough reasons for the analyst to believe that the stock will outperform its peers, and so it makes more sense for investors to have less exposure to the stock in their portfolios. Rating systems that include underweight often also include overweight and equal-weight assessments, either of which is favorable to the underweight rating.
What being underweight on a stock really means
The whole concept of an underweight rating assumes that there's a proper weight that stocks should get in the market. That's the case with the most popular stock market benchmarks, but the weighting system isn't always consistent. For instance, the S&P 500 index is just the biggest of many indexes that weight stocks according to their market capitalization. This method favors the largest companies by giving them a higher weight in the index, while smaller companies get a lower weighting. Meanwhile, the Dow Jones Industrials uses a simple average based on share prices, leading to different weightings in the Dow compared to the S&P 500 and other benchmarks.
Because the proper weighting of a stock depends on the index, you can't necessarily count on an underweight rating to mean that you should own less of one stock than another. For instance, if one stock that has an underweight rating has a market capitalization that's 10 times greater than a different stock that has an overweight rating, it still might be proper for you to invest more money in the underweight stock than the overweight one. However, the disparity in the amount invested would be less than the 10-times difference in their market caps.
How should you handle a stock with an underweight rating?
The other issue that underweight ratings raise is that most analysts won't tell you by how much you should underweight a stock with that rating. Some investors simply avoid it entirely, but that can leave you with substantial underperformance if the analyst's call turns out to be incorrect. Moreover, some analysts have a longer-term view than others in issuing their ratings, and long-term investors might be willing to hold onto stocks that will have below-average returns for a short period of time in order to avoid tax and transaction costs in their quest for above-average returns over the long haul.
Investors shouldn't take underweight ratings too literally and instead should see them merely as an indication from analysts that they think the stock isn't as attractive as others. Whether you agree depends on whether the analysts' reasoning is consistent with your investment thesis and whether your time horizons match up. If the analyst reveals information that you find compelling, then lightening up on a stock with an underweight rating can be an appropriate move for you to make.
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