Education: Growth & Income Investing

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How to Use Zacks Rank #3 (Hold)

While we often preach to limit your search to include mainly Zacks #1 Rank stocks, and, to a somewhat lesser degree, Zacks #2 Rank stocks, long-term investors may want to expand their search to also include stocks with a Zacks Rank of 3. Let’s see why.

Analysts Love the Large-Caps

Large salaries are not the only things that attract equity analysts. They also like to focus their attention on large companies.

Small companies tend to be quite volatile. Stocks that have a high degree of volatility are characterized by large price movements. They are by no means stable companies. As a result, predicting the earnings of smaller companies can be quite a challenge. It is hard for analysts to get their hands around these speculative companies. For this reason, analysts tend to focus their attention on companies that have a history of earnings stability, and these typically are large-cap stocks.

The larger the company, the more analysts covering it. The more analysts that are assigned to cover a company, the more difficult it is for this company to score big on any of the four measures of the Zacks Rank (Learn more about the Zacks Rank). This leads to an overrepresentation of small- to mid-cap stocks comprising the Zacks #1 Rank stock universe.

Zacks #3 Rank Stocks Can Be Perfectly Acceptable

I bet that title attracted your attention. You most likely have heard us refer to stocks with a Zacks #1 Rank as being the “cream of the crop.” It is understandable why. These stocks represent the top 5% of all stocks that are covered by at least one analyst and are expected to experience the strongest earnings estimate revisions in the future.

Growth and income investors, who also typically fall into the long-term investor camp, need to be careful when choosing to invest only in Zacks #1 Rank stocks. Zacks #1 Rank stocks are expected to outperform the market over the next one to three months versus the next several years.

This makes sense because every quarter a company releases a new earnings report. And every quarter the slate is wiped clean on any previous announcements. For this reason, a company can give up its Zacks #1 Rank fairly quickly. This can lead to a high degree of portfolio turnover for those limiting their portfolio allocation solely to Zacks #1 Rank stocks.

Because there is such fierce competition for those slots that make up the top 5% of the market universe, growth and income investors need not worry if their portfolio is made up of some Zacks #3 Rank stocks. Stocks in this camp can still provide excellent upside potential. But one needs to keep a careful eye on these stocks.

Zacks #4 or #5 Rank Stocks Are Not Acceptable

When a company’s Zacks Rank declines to a 4 or 5, this should immediately catch the attention of growth and income investors. Something is fundamentally wrong with this company and its earnings are suffering as a result. While it is okay to remain invested when a stock’s rating falls to a 3, the growth and income investor needs to part ways with Zacks #4 (sell) and #5 (strong sell) Rank stocks.

It is important that the growth and income investor knows when to say when. For those that hang on in hopes of a recovery, this strategy can prove to be extremely costly. Companies that report negative earnings surprises tend to decrease in value over the next one to three months. Furthermore, companies that have a history of negative earnings surprises are more likely to disappoint going forward.

There are thousands of stocks to choose from so why pin your hopes on one that is dropping faster than skydiver without a parachute? Take your money out of this company and invest in a more fundamentally sound one. In the long term, you will be glad that you did.