Underperform ratings are assigned when a stock isn’t expected to do as well as the overall market. Some of the signs that a stock is underperforming include a drop in earnings, underperformance compared with the company’s industry or the benchmark index.
It’s important to keep in mind that underperforming stocks are not necessarily bad investments, and the concern over the potential downside doesn’t always justify a “sell” rating.
In addition, the price of a stock could be underperforming even though fundamentals are strong, giving the word “underperforming” a bullish connotation when referring to price.
What Is an Underperforming Stock?
When an investment analyst assigns an “underperform” rating to a stock this is thought to be less bearish than an outright “sell” rating.
A rating of “underperform” is also sometimes referred to as “weak hold” or “moderate sell.”
In this sense, stocks that have underperforming prices might be considered buying opportunities.
That said, the general definition is a bearish one, similar to the downward trends in a bear market. Meaning: an underperforming security is often one that most investors might want to keep an eye on, and possibly consider selling at some point.
Indicators of Underperforming Stocks
Just as “underperforming” can have slightly different interpretations, depending on the context, there are also many ways to determine whether or not a stock might be underperforming.
Underperforming stocks could be those that have more sluggish prices than their peers, the overall market, or a particular index.
Underperformance could be measured by earnings that lag behind competitors, dividends that haven’t increased, or any number of other economic metrics pertaining to the operations of a business.
And finally, technical or fundamental analysis indicators (those that appear on price charts) could indicate imminent underperformance.
Here are seven signs a stock could be underperforming — which are important criteria to understand when investing in stocks.
1. Falling Earnings
When a company’s earnings are declining instead of growing, this could be a sign of underperformance.
And even when earnings are growing, a stock could still be considered an underperformer if competitors in its industry are seeing greater earnings growth.
Alternatively, an earnings-positive stock could also be labeled “underperform” if a related index has outperformed the price of the stock.
For example, a tech stock listed on the Nasdaq exchange might have had earnings growth of 5% during the last quarter. But if the Nasdaq as a whole gained 10% during that time, an individual stock with 5% growth could be considered an underperformer.
The criteria of underperforming earnings can be compared to a stock’s industry, its competitors, or a related index. And earnings are not the only way to measure underperformance, although they are a common one.
2. Underperformance vs Industry
Stocks can also be said to be underperforming relative to their own industry. This method of gauging performance is often used with stocks that are in a new or highly specialized area of business.
One common way to measure performance in an industry is to look at a related exchange-traded fund that has a large market cap.
3. Underperformance vs Index
A common sign of underperforming stocks is their lack of gains compared with the broader market indices. After all, if a stock doesn’t outperform the market, what’s the point in holding it? Buying a simple index-based fund, e.g. a passive exchange-traded fund (ETF), aims to give the investor market returns over time.
It makes sense to qualify underperforming stocks by comparing them with an index that has some relation to their industry. For tech stocks, that might be the Nasdaq. A broader market index of large-cap U.S. companies would be the S&P 500.
Underperforming in comparison with an index might be the broadest interpretation of the word. A more specific metric of performance has to do with a company’s competitors.
4. Underperformance vs Competitors
Perhaps the most targeted metric of underperforming stocks might be their performance relative to industry peers. If a stock is seeing growth metrics that don’t meet or exceed those of some or all of its competitors, then it can be said that the stock is underperforming.
Companies that have a competitive edge that would be difficult for others to overcome are said to have an “economic moat” — a take on the moat, which makes it harder for people to enter a place.
In financial terminology, having an economic moat means that a company should be insulated from the possibility of its competitors stealing market share and reducing profits.
An example might be a company in the telecommunications or media industry that has the market cornered for a particular service like streaming entertainment or new wireless tech (meaning the business has a lot of customers in a certain area or little real competition). This could be considered an economic moat.
If a company has no moat and is underperforming relative to its competitors, this could spell trouble.
5. Declining Dividends
Another negative thing that tends to happen to underperforming stocks is when they cut or suspend their dividend (for dividend-yielding stocks, of course). This can happen when something called the payout ratio of a stock becomes unsustainable.
The payout ratio is simply the relationship of a company’s earnings per share with how much of those earnings get paid out to shareholders. If a company’s earnings per share are $1, for example, and the stock pays a dividend of 10 cents per share, the payout ratio is 10%.
When a company increases its dividend too much too fast, or earnings fall precipitously, the payout ratio might rise to a level that eats up all of the company’s profits (possibly as high as 100%, meaning all profits go to shareholders as dividends).
When this happens, companies might have to reduce their dividend, or in uncertain times suspend the dividend altogether.
During the financial crisis of 2020, many companies in some of the hardest-hit sectors like real estate investment trusts and retail wound up slashing or suspending their dividend payments.
6. Insider Selling
There’s no one more intimately familiar with the operations of a company than those who spend their days running it. So when insider executives sell shares, it might indicate that something about the company has taken a turn for the worse.
Of course, there are times when executives simply need to raise cash for personal or business reasons. Insider selling doesn’t always mean that a company is underperforming.
Still, looking at the actions of insiders who hold large amounts of shares can be an easy way to judge whether the near-term outlook for a stock will be bullish or bearish.
Most brokerages give users access to this data in a simple bar graph format. The amount of shares and their dollar value attributed to insider buying and selling will be displayed for each month, usually going back several years or more.
7. Moving Average Death Cross
While so far, the signs of underperforming stocks covered here have focused on fundamental factors, this final sign is purely technical (meaning it’s based on charts, not economic numbers).
The so-called death cross pattern happens when a short-term moving average (often the 50-day) moves below a long-term moving average (often the 200-day). This is the opposite of a “golden cross,” which involves a long-term moving average moving below a short-term one, which is a bullish signal.
A technical pattern like this suggests that a stock’s momentum may be faltering and that traders have taken a more pessimistic view toward the security. Once an indicator like this is confirmed, it doesn’t take much time for traders around the world to recognize and act on it.
A Common Denominator
These aren’t the only signs that a stock might be underperforming. There are many relevant economic and technical indicators not mentioned here. A common theme ties them all together, though.
Underperforming stocks are those that are not doing as well as some other related benchmark, or those that have been performing worse than their own historical precedent.
Underperformance could be a sell signal or a buying opportunity. It depends on the context, but most analysts assign an “underperform” rating to stocks they think might not have a compelling reason to be bought at the moment.
Signs of underperformance can include a drop in earnings, lower performance when compared with industry averages or a benchmark index, as well as other factors like declining dividends. All that said, however, an underperforming stock doesn’t automatically signal that it’s a loser — buying underperforming or undervalued securities can sometimes present an opportunity.
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