Who Benefits from Analyst “Top Picks”?

René M. Stulz is Everett D. Reese Chair of Banking and Monetary Economics at The Ohio State University Fisher College of Business. This post is based on a recent paper authored by Professor Stulz; Justin Birru, Associate Professor Finance at The Ohio State University Fisher College of Business; Sinan Gokkaya, Professor of Finance at Ohio University College of Business; and Xi Liu, Assistant Professor of Finance at Miami University of Ohio Farmer School of Business.

In the early 2000s, concerns about conflicts of interest of sell-side analysts led to new regulations and eventually to the Global Analyst Research Settlement. One important byproduct of these regulations is the adoption of a new stock rating system by most leading investment banks. Before the Global Settlement, 85% of analyst recommendations are issued using a traditional five-tier rating system, but only less than 20% are afterwards.

Though a coarser three-tier rating system has the potential to reduce gains to analysts from engaging in strategic behavior, such a system also reduces the information available to investors. That is, sell-side analysts cannot fully discriminate among stocks whose performance they expect to be superior. To mitigate the costs of a coarser three-tier stock rating system, we would expect brokerage houses to attempt to increase the granularity of information available to financial market participants by devising new ways to draw attention to their best stocks. Consistently, we show that a new stock designation, “top picks,” emerges following the Global Analyst Research Settlement and its use becomes widespread mostly among three-tier brokers. A top pick is typically the stock for which the analyst has the strongest conviction of superior performance compared to other buy recommendations.

Exploiting a novel and comprehensive sample of 3,563 top picks by 113 unique brokerage houses over 1999-2016, we find in our paper titled Who benefits from analyst ‘top picks’? that top picks attract more retail, institutional and financial press attention and affect the trading of both institutional and retail investors more compared to buy recommendations. We investigate whether potential conflicts of interest affect the choice of top pick stocks, and whether the market and investors can see through designations potentially tainted by conflicts of interest. Although investment banking clients are more likely to be selected as top picks, top pick designations, on average, have superior investment value for investors. Top picks with poor ex post investment performance are more likely to be investment banking clients. While top pick designation announcements have a strong positive stock price reaction, the stock price reaction for top picks that have poor ex post performance is neither statistically nor economically significant, which suggests that the market does not credit poor top picks when they are announced. Top picks that have poor ex post performance are costly for analysts in that they worsen their career prospects and hurt their credibility with investors.

Top picks differ from stock recommendations in a number of ways. First, a top pick is not a recommendation but an optional designation that represents an analyst’s highest conviction “single best” idea within her coverage universe. In contrast, a buy recommendation typically means a stock is expected to outperform its industry peers. Hence, there can be at most only one top pick selection while there are multiple buy rated stocks outstanding by the same analyst at a given point in time. Second, unlike stock recommendations, “top pick” designations are assigned to a stock only for the upcoming one-year investment horizon (typically at the end or beginning of the year, with December, January, and February accounting for 66% of top pick announcements) and almost always expire on December 31st. Third, top picks appear to be intentionally used as a marketing tool for brokerage houses. Indeed, a primary reason for the clustering of top picks in December – February is so that brokers can advertise stocks as top picks for the upcoming calendar year. In addition, brokers frequently organize best idea conferences to which they invite institutional clients and showcase their top pick selections, and product marketing teams periodically update investors about the performance of top pick selections through regular publications.

Top picks are increasingly common in the period following the regulatory changes of 2002. In 2000, before the reforms, only 5 firms are designated as top picks. In the year after the Global Analyst Research Settlement, there are 49 top picks. The number of top pick stocks continues to exhibit a steep upward trend in the years immediately following the Settlement. On average, from 2005 to 2016, there are 267 top picks every year.

We find strong evidence that the top pick designation draws significant attention to a stock. We measure the attention of retail (institutional) investors by the Google Search Volume Index (Bloomberg search activity) and document that both retail and institutional investors devote more attention to announcements of top picks relative to that of buy recommendations in the same industry or in the same analyst’s coverage universe. We next examine whether increased investor attention extends to the financial press and find more pronounced press coverage of top picks. In economic terms, 48% of top picks receive media coverage during the event window surrounding their announcements compared to only 25% (30%) for industry-year (analyst-year) matched buy recommendations. Furthermore, top picks are discussed in about three times as many financial news articles relative to buy recommendations.

We find strong evidence that top pick designations have investment value on average. For instance, a calendar-time portfolio comprised only of analysts’ top picks earns roughly 1.33% characteristic-adjusted monthly returns (17.18% in annual terms) compared to only about 0.51% (6.29% in annual terms) for buy recommendations of the same analyst in a given year. In addition, the top picks’ outperformance extends to buy recommendations issued in the same industry by other analysts.

The evidence suggests that analysts exhibit skill in identifying their highest conviction best ideas and that strategic motives are unlikely to be important for an average top pick in that investors gain from following the investment advice. However, not surprisingly, there is cross-sectional variation in the investment performance of top picks. In principle, the ex post poor performance of a top pick should be a surprise to investors if analysts are skilled and designate a stock as their top pick with high conviction. Hence, if poor performing top picks can be discerned when the designation is announced, it reflects either that the analyst making the designation lacks skill and is perceived as such by investors or that the analyst has skill on average but the designation is influenced by conflicts of interest. To identify top picks most (least) likely to reflect genuine best investment ideas, we separately focus on top picks in the top (bottom) quartile of ex post investment performance. We call top picks in the top (bottom) quartile good (bad) top picks. We find that bad top picks are more likely to be investment bank affiliated stocks. However, if bad stock picks are designated to provide booster shots to investment banking clients, they do not appear to be helpful to these companies as the market is not fooled by such behavior. Specifically, we find that bad top picks are not associated with a significant positive stock price reaction but good top picks are.

We next turn our attention to trading behavior of financial market participants and examine whether institutional and retail investors value top picks and discern among bad and good top pick designations when they are announced. Examining institutional trading imbalances in the days around the top pick announcements with 286 million daily equity transactions obtained from Ancerno Ltd., we find that institutional investors trade top picks at a greater intensity relative to stock recommendations, and seem to be able to discern whether a top pick is good or bad when it is announced. In economic terms, the average institutional buy-sell trading imbalance is 2.99% to 5.04% higher over the two-day event window surrounding the announcement of good top picks. In contrast, the average institutional trading imbalance is 3.5% to 4.7% lower over the same event window for bad top picks.

Finally, we consider reputational and potential career implications of top picks for sell-side analysts. We uncover evidence suggesting that analysts pay a reputational cost for bad top picks. We find that the stock-price reaction to recommendation upgrades/downgrades by an analyst is lower in the year after the same analyst makes a bad top pick selection, consistent with the marketplace disciplining analysts selecting bad top picks. We also find that analysts that select bad top picks are more likely to be demoted to lower ranked brokerage houses. Further, analysts that chose good top picks are more likely to be subsequently selected to Institutional Investors’ All-American team.

The complete paper is available for download here.

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