Analyst Top Picks work

Since 2002 equity analysts in the US have been forced to use a three-tier rating system for the stocks they cover. This Buy/Hold/Sell scheme has become ubiquitous worldwide now, but with it also came the trend towards analysts picking their high conviction ‘Top Picks’ in their coverage. This brings us to the question if analysts are able to pick the winners among their winners, i.e. do analyst Top Picks perform better than analyst buy recommendations on average?

The short answer for the TikTok generation is: Yes, analyst Top Picks outperform the average buy-rated stock.

Outperformance of analyst top picks vs average buy-rated stock

Source: Birru et al. (2020). Note: The alpha shown is annualised. In practice, most top picks remain Top Pick for several months, but less than a year.

For all the rest of us who have an attention span longer than a goldfish, there is some nuance to it though, that is important to keep in mind as Justin Birru and his colleagues describe.

First, analyst Top Picks on average tend to be more frequently house stocks, where the company is an investment banking client, than the average buy-rated stock. On average, a house stock is about twice as likely to be picked as a Top Pick than a buy-rated stock that isn’t a house stock. Interestingly, despite this bias, house stocks that are selected as Top Picks still on average perform better than the average buy-rated stock by the same analyst. The outperformance is only about half as much as for analyst Top Picks that are not house stocks, but it still is worthwhile for investors to pay attention to analyst Top Picks even if they are house stocks. This is encouraging since analysts tend to do a good job selecting the stocks that perform well despite the occasional conflict of interest.

Even more important for both analysts and investors is that analysts cannot fool the market with Top Picks that are investment banking clients or that perform poorly. On average, stocks picked by analysts as Top Picks see more media attention and trading as investors try to gain exposure to these high-conviction ideas. But Top Picks that are house stocks tend to see a smaller increase in trading volume than Top Picks that are not house stocks. Investors aren’t stupid. If an analyst picks a Top Pick that is also a house stock, investors take this recommendation with a grain of salt. If they are convinced of the underlying fundamental case, they still will trade in this stock, but they will not just accept an analyst recommendation at face value.

And over time, investors learn which analysts they can trust. By splitting analyst Top Picks into stocks that end up in the top quartile by performance afterward vs. stocks that end up in the bottom quartile, the authors of the study were able to track what happens if an analyst makes poor Top Pick recommendations. Every analyst will have a poor-performing recommendation from time to time. That is normal and part of the job. But over time, investors learn, which analyst recommendations they can trust and which ones they cannot. Analysts with poor-performing Top Picks will face declining influence in the market and increasing career risk. Declining influence insofar as trading volume in response to their selection of Top Picks declines if investors don’t trust the analyst. Increasing carer risk insofar as analysts with poor-performing Top Picks are more likely to lose their jobs or be demoted.

So, in general, analyst Top Picks are well worth paying attention to. They tend to work, and they give investors a simple and easy way to track the quality of an analyst. And for analysts, it pays to choose their true Top Picks because they face adverse consequences if they just try to curry favour with house stocks. All that will do is ruin their reputation in the market, which is why analysts are eager to pick their best stocks to the best of their abilities.