Investment firms and brokerage houses are increasingly using ‘top picks’ to supplement stock recommendations (Chart 1). These ‘highest-conviction best ideas’ are typically announced December-February and garner significantly more media attention.
An NBER paper examines these top picks’ stock performance and whether analysts use them to inflate the value of their clients’ stock prices. They find the following:
Top picks generate greater excess returns than traditional buy recommendations (17% annualised excess returns (1.33% monthly), compared with 6.5% for buy recommendations).
They are characterised by higher expected EPS and stock return performance, tend to be issued by relatively larger firms, are more likely to be growth and momentum stocks, and are more visible to the investment community. Further, their selection is negatively associated with uncertainty and risk.
Bad top picks are more likely to be ‘strategic selections’. That is, they are more likely to be affiliated with the investment banking arm of the analyst’s brokerage house. However, the analysts recommending these bad top picks are generally penalised by demotions.
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Summary
- Investors and media outlets pay significant attention to analysts’ ‘top pick’ stock recommendations.
- This attention is justified: the picks offer large excess returns. The caveat is that some analysts appear to exploit this influence (but suffer consequences).
The Study in a Nutshell
Investment firms and brokerage houses are increasingly using ‘top picks’ to supplement stock recommendations (Chart 1). These ‘highest-conviction best ideas’ are typically announced December-February and garner significantly more media attention.
An NBER paper examines these top picks’ stock performance and whether analysts use them to inflate the value of their clients’ stock prices. They find the following:
- Top picks generate greater excess returns than traditional buy recommendations (17% annualised excess returns (1.33% monthly), compared with 6.5% for buy recommendations).
- They are characterised by higher expected EPS and stock return performance, tend to be issued by relatively larger firms, are more likely to be growth and momentum stocks, and are more visible to the investment community. Further, their selection is negatively associated with uncertainty and risk.
- Bad top picks are more likely to be ‘strategic selections’. That is, they are more likely to be affiliated with the investment banking arm of the analyst’s brokerage house. However, the analysts recommending these bad top picks are generally penalised by demotions.
What Are Top Picks?
In 2002, the NYSE introduced new regulations (Global Analyst Research Settlement) to reduce concerns over conflicting interests in sell-side analysts’ stock recommendations. For example, the fear was that they were making overly optimistic stock recommendations to help their firm’s investment banking arm.
Post-Global Settlement, investment firms and brokerage houses transitioned from a five-tier system of recommendations to a three-tier one. The move reduced granularity in recommendations, so instead brokerages supplemented the three-tier system with an annual ‘top pick’.
Top picks represent an analyst’s highest-conviction best idea among their coverage portfolio of stocks. The picks give sell-side analysts room to distinguish stocks whose performance they expect to be superior. These differ from stock recommendations in at least four ways: (i) they are a single best idea, (ii) they are assigned to a stock only for the upcoming one-year investment horizon, (iii) they represent a stand-alone research output (Chart 2), (iv) they are intentionally used as a marketing tool for brokerage houses.
What Makes a Stock Recommendation a Top Pick?
By estimating logistic regressions, certain characteristics appear to drive an analyst’s top pick choice. First, and most obvious, selection is based on expected performance. Analysts expect higher EPS and stock return performance from top picks compared with buy recommendations. In addition, best-idea stocks tend to be issued by relatively larger firms and are more likely to be growth and momentum stocks as measured by the book-to-market ratio and the past 12 months’ returns.
Crucial to the paper’s findings, however, is that analysts do not simply follow a mechanical rule of selecting stocks with the highest target price implied stock returns. For instance, top pick stocks are also more visible to the investment community, and the likelihood of a stock being identified as top pick is negatively associated with uncertainty and risk.
Furthermore, there appears to be scope for conflicts of interest. The authors continue to find evidence of a ‘strategic bias’. That is, investment-bank-affiliated stocks are 97.56% more likely to be designated as top picks compared with unaffiliated stocks.
Should Investors Take Note of Top Picks?
Absolutely! The authors construct a portfolio comprising top picks and another comprising industry-year matched buy/strong buy recommendations but without a top pick designation. They calculate portfolio excess stock returns.
Comparing top picks vs stock recommendations by the same analyst during the same year, top pick stocks generate 17% annualised excess returns (1.33% monthly), compared with 6.5% for buy recommendations (Chart 3). Comparing performance across analysts in the same industry and year, monthly returns accrued to top pick stocks are 90bps higher relative to those of positive recommendations.
Both tips generate strong investment performance. But investors must act quickly to generate abnormal returns on buy recommendations. Unlike top picks, investing five trading days after an announcement will yield no statistically significant excess returns.
This top pick outperformance justifies the attention devoted by both retail and institutional investors to their announcements. Indeed, the authors find that top pick designation draws significantly higher raw and abnormal attention relative to buy recommendations over [0,+5] days surrounding the announcement.
When Should Investors Avoid Top Picks?
There are both good and bad top picks. The authors designate this binary classification depending on the percentile ranking of abnormal stock returns across top picks for the same industry, for all analysts in a particular year.
Historically, bad-performing top picks are more likely to be affiliated with the investment banking arm of the analyst’s brokerage house (defined as the stock of a firm which used the investment bank for an IPO or a common stock issued over the last two years). Also, when selecting these bad top picks from buy recommendations, analysts do not choose ones with higher EPS forecasts or target price implied returns.
Interestingly, the authors find evidence that investors are wary of strategic biases. Top picks that end up yielding poor returns (and are more likely to be selected in the interest of clients) tend to have insignificant stock price reactions. That is, investors ignore these bad recommendations.
Are Analysts Penalised for Poor Recommendations?
Yes! Financial market participants, on average, react more strongly to the announcement of top picks compared with stock recommendations. They are also able to distinguish between good and bad top picks. Given these factors, there can be significant career and reputational consequences for analysts.
The paper finds that the stock price reaction to recommendation upgrades/downgrades by an analyst is lower in the year after that analyst selects a bad top pick. Also, analysts who recommend bad top picks are more likely to be demoted to lower-ranked brokerage houses. Meanwhile, analysts who make good top picks are more likely to be subsequently selected to the IIM’s all-star roster.
Bottom Line
The ability to garner exceptional attention with their top picks may tempt analysts to pursue strategic objectives with their choice. For example, they can select a current or potential investment banking client as their top pick. Selecting a client purely for strategic reasons will, however, not only have an insignificant impact of that client’s stock price, it will also hinder the analyst’s career prospects.
The takeaway for investors is that it is worth paying attention to top picks. The analysts providing them devote significant effort to selecting them. The heightened media attention and the real reputational stakes ensure these top-pick selections are, on balance, credible. They are also valuable over both an immediate and longer-term horizon.
Click here to view paper
Sam van de Schootbrugge is a macro research economist taking a one year industrial break from his Ph.D. in Economics. He has 2 years of experience working in government and has an MPhil degree in Economic Research from the University of Cambridge. His research expertise are in international finance, macroeconomics and fiscal policy.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)