Upgraded Broker Ratings

I’m sure a lot you have experienced the pleasure of waking up and finding that a covering broker upgraded their rating on one of your stocks.

I’m also guessing that you probably experienced the opposite, and found that one of the brokers downgraded your stock.

While nobody can perfectly guard against downgrades (or forecast all upgrades), it’s important to know how the market reacts. Therefore, you can stay in your upgraded winners (or buy if you’re on the fence) and consider getting out if a downgrade comes your way.

When I’m screening for new stocks, I like to look for companies that have recently seen a broker rating upgrade. Tests have proven that stocks with broker rating upgrades outperform those that don’t get upgraded and really outperform those that get downgraded.

But by how much?

I created three screens and ran some tests. Each screen used a price and volume qualifier of >= $5 and >= 50,000 shares traded daily (avg. 20-day volume). I then added my Average Broker Rating Change (ABR) filter.

• Screen 1 had no upgrades or downgrades –- the ABR remained the same, i.e., no change.
• Screen 2 looked for only those companies that received upgrades (positive changes in their average broker rating).
• Screen 3 screened for only those stocks that have been downgraded, i.e., negative change in their average broker rating.

The tests confirmed what I had already suspected – but with a much larger magnitude. (I ran 4 separate tests over the last 8 years (2000 through 2007) on a ‘Combo’ strategy with the Research Wizard’s Advanced Backtester to see just how different the results would be with this different filter. (Each test used a four-week rebalancing period and was tested over multiple start dates to verify the robustness of the results.)

Results

The screen with no upgrades or downgrades (their rating, whatever it was, stayed the same) produced an average of a 79.6% total compounded gross return over the last 8 years (or an average compounded annual growth rate of 7.6%).

The screen with only positive broker rating upgrades produced an average total compounded gross return of 111.0%, for a compounded annual growth rate of 9.8%.

The screen with only downgrades, however, performed significantly worse with an average total compounded gross return of only 30.8%, for a compounded annual growth rate of only 3.4%.

The screen with the positive broker rating changes performed nearly 3 times that of the downgrades screen. And while 9.8% doesn’t seem like a big jump from 3.4%, you can see that by consistently focusing on upgraded stocks, it meant the difference between more than a 100% return after 8 years in comparison to less than a third of that.

Below is an example of one of the tests I ran in the Research Wizard’s Advanced Backtester. In this test, the Blue Line represents the screen with no change in the average broker rating. The Orange Line represents the screen with the broker rating upgrades. And the Turquoise Line shows the screen with the downgrades. (The Maroon Line represents the S&P 500.)

After running the upgrades screen, I added the Zacks #1 Rank to it and more than doubled the returns, taking it from a 9.8% compounded annual growth rate to over a 22.9% growth rate.

Here are 3 stocks from that list for this week (7/9/08):

Flir Systems [[flir]]
The9 Limited [[ncty]]
Marvell Tech Group [[mrvl]]

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