By the time you’re done reading this article, you'll learn the downgrade meaning as well as how to protect your portfolio against analyst downgrades in the future. It can save your portfolio significant value and give you added peace of mind that you won't be blindsided when the market suddenly moves against you in the form of an unexpected downgrade.
What is a Downgrade?
How do you define downgrade — what is downgrading, exactly? “Downgrade” means that a research analyst lowers their rating on a stock, typically because they believe the stock price will fall in the future. Analysts usually do this by giving a stock a “sell” rating.
In practice, a stock downgrade happens when an analyst who follows a company believes that the current market price of the stock is not justified by the company's fundamentals and technicals in the short term. Analysts typically issue ratings four times a year, which is when stocks may be downgraded to “sell,” upgraded to “buy,” or assigned a “hold” rating.
Analysts may also issue stock downgrades suddenly as well as at regular intervals. These downgrades may also be more long-term in nature as opposed to short-term predictions.
As you might expect, downgrades are the opposite of stock market upgrades. You can see a list of the most recently upgraded stocks on MarketBeat.
How Downgrades Work
Downgrades can have a big impact on a stock price and can cause investors to sell their shares. In turn, it can cause the stock price to fall even further.
Analysts can downgrade a stock in a few different ways.
The most common is to simply lower their rating on the stock. This means that they think the stock is now a less attractive investment than it was previously. Another way is for them to revise their stock price targets and analyst ratings at the same time. If they lower their target price, it means that they think the stock is less likely to reach its previous price target.
Lastly, analysts can also change their recommendations for a stock. If they recommend that investors sell a stock, it is likely that the stock price will fall.
Downgrades can have a big impact on stock prices and investors should pay attention to them. However, it’s important to remember that analysts are not always correct — don’t consider downgrades as the only factor when making investment decisions.
Bond Downgrades
Bond downgrades occur when a credit rating agency lowers a bond issuer's credit rating. This action is generally taken in response to deterioration in the issuer's financial condition, which may make it more difficult for the issuer to meet its debt obligations. The downgrade may also reflect a change in the agency's assessment of the issuer's ability to repay its debt.
Bond downgrades can have a number of effects on the issuer, the market for the bonds and the investors who hold the bonds. The most immediate effect is typically a decline in the market value of the bonds as investors demand a higher yield to compensate for the increased risk. This can put pressure on the issuer as it may need to offer higher interest rates to attract buyers for new bonds.
The downgrade may also make it more difficult and expensive for the issuer to raise new capital, as lenders may be hesitant to extend credit to a company with a lower credit rating. In some cases, the issuer may be forced to offer higher interest rates or accept less favorable terms in order to obtain financing.
Bond downgrades can have a ripple effect on the markets. They may lead to higher borrowing costs for other companies and may trigger selling by investors who hold other bonds that are now considered to be at greater risk of default.
Reasons for a Downgrade
What are some common reasons why analysts choose to downgrade stocks? Let’s take a look.
Reason 1: Analysts expect a company's earnings to decline in the future.
An analyst may downgrade a stock when earnings are expected to decline because the company may not be able to sustain its current level of profitability. The analyst may also have concern about the company's ability to grow earnings in the future.
A downgrade means stocks should logically trade at their intrinsic value, which is reflected in the amount and quality of their earnings. If earnings are expected to fall, then the company's share price should also follow suit by heading lower. This is a common element of 52-week low stocks.
Reason 2: A company weakens its competitive position.
When a company’s competitive position weakens, its stock price will likely fall. A weakened competitive position means that a company decreases its ability to generate sales and profits. As a result, analysts will often downgrade the stock of a company whose competitive position has weakened.
A company’s competitive position can weaken in several ways. For example, a company may lose market share to its competitors. This can happen if the company’s products no longer have the same competitive edge. Alternatively, a company may face new competition from firms that enter its market.
Reason 3: A company faces increased regulation or other headwinds.
Increased regulation could lead to a downgrade for a number of reasons. First, it could lead to higher costs for the company, either due to the cost of compliance or if the company is found violating new regulations.
Second, increased regulation could lead to reduced demand for the company's products or services. This could mean that products or services are less safe or because the company is less trustworthy. Finally, increased regulation could lead to a reduction in the company's profitability.
Reason 4: A stock is overvalued relative to its peers.
An analyst may downgrade a stock because it is overvalued. The company's earnings may be weaker than expected or maybe an analyst believes that a stock's price has simply gotten ahead of itself. In any case, when a stock is overvalued, it means that the market puts a higher price tag on the stock than what the analyst believes it is actually worth.
This can create a situation where the stock is at risk of a sharp drop if it faces bad news or a sell-off in the market. For these reasons, it's important to be cautious with stocks that are overvalued. A stock may continue to rise in price even when it is overvalued but there is also a greater risk of a sudden and sharp decline.
Reason 5: Analysts are becoming less bullish on the overall market.
Analyst downgrades may occur because they are less bullish on the overall market. In other words, the analyst believes that a stock market will head for a downturn and, as a result, the stock in question will likely underperform the market.
There are a number of reasons why an analyst may become less bullish on the overall market. For example, the analyst may have noticed that economic indicators have started to point to a slowdown in growth. One of these factors might be the slowdown in consumer spending at major retail outlets. (Learn more about retail sector investing ideas.) Analysts may also believe that valuations have become stretched and that a correction is overdue.
Warning Signs of a Downgrade
Several key warning signs can precede an analyst downgrade by the most accurate Wall Street analysts.
- A fall in the company's stock price: This is usually the first sign that something is wrong and that an analyst downgrade may be forthcoming.
- Diminished financial outlook: If a company's financial outlook worsens, it may be a sign that an analyst downgrade is on the horizon.
- Negative earnings surprises: If a company consistently misses earnings estimates, it is another sign that an analyst downgrade may be imminent.
- Weakening competitive position: If a company continues to lose market share or its competitive position continues to weaken, this may be a sign that an analyst downgrade will come soon.
- Changes in management: If a company's management team is in flux, it may be a sign that an analyst downgrade is on the horizon.
If you see any of these warning signs, it may be time to sell your shares or take other action to protect your portfolio.
Take Stock Downgrades into Consideration
Analysts downgrade stocks for a number of reasons, but they mostly hinge on them becoming less bullish on the company's short- and long-term prospects. No analyst recommendation is infallible but it’s a good idea to take downgrades more or less into consideration.
