When stock analysts single out one company as their “top pick,” it pays to listen. A portfolio of those picks generated abnormal returns of 17.6% a year, more than ordinary buy ratings delivered.
The finding comes from Justin Birru and René M. Stulz of Ohio State University’s Fisher College of Business, Sinan Gokkaya of Ohio University and Xi Liu of Miami University’s Farmer School of Business. Their paper, “Are Analyst “Top Picks” Informative?,” was published online in The Review of Financial Studies on December 23, 2023.
A label born of regulation
After conflicts of interest among sell-side analysts led to the Global Analyst Research Settlement in the early 2000s, most big brokers switched from five-tier ratings to a coarser buy, hold and sell system. With more than half of covered stocks still rated buy, analysts needed a way to flag the ideas they believed in most.
The answer was the top pick: one stock, usually announced between December and February, designated as an analyst’s single best idea for the coming year. Brokers market them heavily. Yet top picks are not recorded in the standard IBES database researchers use, so the authors assembled their own sample. An earlier version of the study covered 3,563 top picks from 113 brokerage houses between 1999 and 2016.
Better returns despite banking ties
There was reason for suspicion. In the earlier version, stocks of companies that had recently used the analyst’s bank for an IPO or share issue were almost twice as likely to be named a top pick.
Even so, top picks had greater investment value than buy recommendations and other analyst strategies, according to the published paper. In the working paper, a calendar-time portfolio of top picks earned about 1.33% a month in characteristic-adjusted returns, against about 0.51% for the same analysts’ buy ratings.
Top picks also drew attention. In the earlier version, 48% received media coverage in the days around their announcement, compared with 25% of comparable buy recommendations in the same industry.
Institutions can tell good picks from bad
Both institutional and retail investors traded in response to top picks. But only institutional investors appeared to identify the top picks with greater investment value at the time they were announced.
The working paper found that the worst-performing quarter of top picks were more likely to be investment banking clients, and that the market’s price reaction to these bad picks on announcement was not significant. Bad picks also carried a cost for the analysts who made them, worsening their career prospects and their credibility with investors.
Study Details:
- Title: Are Analyst “Top Picks” Informative?
- Authors: Justin Birru, Sinan Gokkaya, Xi Liu, René M. Stulz
- Journal: The Review of Financial Studies
- Publication Date: December 23, 2023
- DOI: 10.1093/rfs/hhad099