Limitations of the Zacks Rank

For as powerful an investment tool as the Zacks Rank is, it is by no means fool proof. Below are listed the main limitations of the Zacks Rank. Without considering these potential shortfalls, it is possible to make investment decisions that are not suitable for your long-term goals or risk tolerance. Please make sure that you understand this section fully before using the Zacks Rank to enhance your investment returns.

Performance Relative to the Market

The movement of the overall market plays a large role in determining how stocks will perform. As such it is very difficult for a stock to rise in the face of a bear market. We can see countless examples of this happening during the market downdraft since 2000. Thus, it is better to think of the Zacks Rank as an indication of a stocks relative performance to the overall market. For example, if the market is tumbling down then a #1 Rank stock will most likely be down, but not as much as the overall market. And when the overall market is up, then a #5 Rank stock may very well be up, but not to the same degree as the average stock. Yet it is interesting to note that the Zacks #1 Rank stocks overall did produce profits in 2000, 2001 and 2002 (+14.3%, +24.3% and +1.2% respectively during this bear market stretch.)

Short-Term Indicator

With 17 years of data behind us we know conclusively that the effects of earnings estimate revisions are good for a 1-3 month time frame. This makes sense when you consider that every three months a company will provide a new round of earnings that wipes the slate clean on any previous announcements. Yet, even long-term investors get caught up with the fever for wanting to own just #1 Rank stocks. Unfortunately being long-term and a #1 Rank zealot are not compatible. Remember that only the top 5% of companies receiving positive estimate revisions in the last 60 days will be a Zacks #1 Rank stock. There is pretty stiff competition for those slots in the top 5% and a company can be on today and be off tomorrow if another company receives stronger estimate revisions. However, that company that slipped out of the #1 Rank position may still be an excellent investment. So, long-term investors should be comfortable with ownership of shares that have Zacks Ranks between 1-3. Then use any slippages to #4 or #5 to trim or completely sell your position in the stock.

Market Cap Bias

The larger the company, the more analysts are likely to cover the stock. The more analysts cover the stock, the tougher it is for the stock to score big on any of the four measures of the Zacks Rank. Thus, the list of Zacks #1 Rank stocks will be over represented by small- to mid-cap stocks. That is why a Zacks #2 Rank large-cap stock is actually a very good thing and one with a Zacks #3 Rank may still provide excellent upside potential relative to the overall market. Remember to keep a diversified portfolio that includes a mix of stocks by market cap and by industry.

Too Many Speculative Stocks

Earnings for speculative stocks (such as technology, internet and bio-tech) are the hardest to predict. That's because small companies make up the bulk of the speculative stock universe and due to their size they do not get as much coverage by brokerage analysts. Further the uniqueness of their product lines makes revenue and profit predictions very difficult. When things go well for these companies, then the above attributes lead to exceptionally high scoring for the Zacks Rank. So, those who strictly adhere to buying #1 Rank stocks may end up having a disproportionate number of small growth companies in the tech, internet and bio-tech industries. This creates a lot of volatility depending on how the market likes these sectors at any given time. Here again, the need to keep a diversified portfolio should always outweigh an investors desire to blindly invest in #1 Rank stocks because you do not want to be severely over-weighted in any one sector.

Blind to Everything, But Four Measures

There are only four measures used to calculate the Zacks Rank. Three of the four measures look at analyst earnings estimate revisions; Agreement, Magnitude, and Upside. The fourth measure considers the size of the most recent earnings surprise. You will note there is no accommodation for other fundamental metrics such as P/E, book value, ROE, ROA, debt ratios, growth rates, etc. Nor does it consider technical attributes such as recent changes in price or volume. Thus, in reality the Zacks Rank acts as an initial filter that provides a raw list of potentially successful investment candidates. With these raw lists you can do additional research according to your own investment criteria.

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Zacks Rank Guide Table of Contents

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