Here, we have two workouts aimed at helping us to understand the different research rating systems. Now, we've been told for the first workout that a US consumer analyst has calculated the following target prices for their three stocks undercoverage and their stock A, stock B, and stock C And we've been asked to identify the likely rating for each stock using an absolute rating system the likely rating for each stock using a relative rating system. And finally the likely sector rating. You can see here we've got the target price for stock A, stock B and stock C, and also the current share price for those stocks as well. Now the first thing that I'm going to do is to calculate the upside or downside potentials. That's the target price divided by the current share price minus 1 and the upside potential there for stock a is 10.8% When I copy that formula down we can see that stock B has upside potential of 15.1% and stock C has upside potential of 6.9%. So all three stocks are going to generate upside potential based on the analyst target price.

Let's start off with the absolute rating. Now since all three stocks are going to generate upside potential and quite a significant amount of upside potential. We would assume that on an absolute rating system. We're going to put all three of these stocks on a buy recommendation.

Now, let's have a look. At rating of each stock now although they are all going to generate upside potential based on the analyst target price, the amount of upside is really quite different with stock B generating the most upside potential and stock C generating the least upside potential. Now remember with a relative rating system what we care about is the performance relative to the sector as a whole and will assume that this is a very small sector with just these three stocks in and so for that reason we would put probably stock B on an overweight rating and stocks see on an underweight rating. Now I'm going to abbreviate these overweight is ow. Underweight is uw and therefore stock A which sits in the middle, we're going to put that on an equal weight rating. So those are the relative ratings but remember with a relative rating system we also need a sector rating. Now if we think this sector is going to outperform the market as a whole let's say that the market returns are expected to be six or seven percent then actually as a whole this sector is going to outperform the average of these three will definitely give us upside of more than six or seven percent so we would put this sector on a positive rating. Now, let's have a look at the second workout.

So here we've been told that a fund owns Stock A, B, and C from the workout above in its portfolio and the allocation in its portfolio matches that of its benchmark index. If the portfolio manager acts on the advice of the analyst which stocks are they likely to increase their allocation to if, and then we've got three scenarios. Now the first scenario is that the funds can invest in the whole of the market and is actively looking for stocks with more than 5% upside potential so we can choose from any stock in any sector and we can see that stocks A, B and C will all generate returns of more than five percent based on the analyst target price. So here we'll assume that the portfolio manager will increase that allocation to stocks a b and also see and then of course in portfolio manager would need to think about which stocks it would need to divest from bearing in mind, if a portfolio manager increases their allocation to certain stocks they also have to reduce that allocation to other stocks and in another sector for example.

So the next scenario is that the fun specializes in the consumer sector and is benchmarked against a consumer index. So what you care about here, if you are this fund manager is making sure that your outperforming the consumer index. So your outperforming the average performance of this sector. Really a relative rating system is much more useful in this scenario and therefore the portfolio manager is likely to want to buy more of Stock B. And again because it's by more of one stock, it's going to have to reduce its allocation to another stock and likely it would reduce its allocation to stock C. The third scenario is that the fund can invest in the whole of the market and the portfolio manager wants to maintain a market waiting to the consumer sector. So let's assume that the consumer sector is 10% of the overall Market this portfolio manager will need to make sure that the stocks that it invest in for the consumer sector represent 10% of its total portfolio, but the port manager will want to maximize their exposure to those consumer stocks which are going to perform best and again, it's a relative rating system which helps in this scenario. Again, the portfolio manager is likely to want to increase the allocation to stock B, and probably will want to divest or reduce its exposure to stock C. So hopefully you can see that different rating systems help in different types of scenario and given that many fun managers are selecting their stocks by comparing them to other companies within the same sector. It's usually a relative rating system, which is the most useful.