​Can Paid-For Micro-Cap Research Have Value for Investors? OTC Markets is Betting It Does

Joel Anderson  |

It’s hard out here for a small cap. Despite being the primary driver of job growth in this country, Wall Street’s smallest firms have the most trouble getting the public markets to work for them. Aside from the tremendous costs associated with being a public company, small- and microcap companies have to further deal with an increasing lack of attention. Despite offering the biggest potential returns, smaller companies tend to be shunned by large and small investors alike because of the perception that small- and micro-cap stocks are too risky.

At the core of this issue is a lack of information. Sure, smaller companies generally carry more risk for investors and display more volatility, but they more than balance that out with the potential for much larger returns than exist in larger, more established companies. When part of a balanced, diversified portfolio, they can be invaluable. But they also lack the sort of prolific and detailed research reports that are usually readily available for larger public companies. Even for investors interested in taking on a little more risk in search of big returns, doing so without having access to the sort of expert opinions and research analysis they’re accustomed to is a non-starter.

That’s why OTC Markets Group Inc. (OTCM) is taking a firm step to combat this with the introduction of its new Research Marketplace. The Research Marketplace is an online portal where OTC companies can go to find research firms that can provide coverage for their companies and potentially increase their exposure to investors. By helping companies find and vet research firms, OTC Markets Group is helping small companies create the sort of materials that will ultimately make them more appealing to the investing public and more accessible to institutional investors.

Micro Caps Have Paid a Steep Price for Large-Cap Market Efficiency

While digitization has clearly brought a wave of efficiency to financial markets that was a general improvement, it also had some negative consequences, among those being that the most profitable stocks for sell-side institutional players and market makers became those with the most volume.

One consequence of that has been the almost complete erasure of small-cap research. Typically, equities research is performed by large firms as a service for their clients and is paid for by commissions from trading and investment banking. However, that means that for smaller, less actively traded companies – the ones that would benefit the most from research reports – the incentives for research coverage just aren’t there.

“Most analyst coverage is still paid for by trading, and a lot of the large investment banks have cut back,” says Jason Paltrowitz, Executive Vice President of Corporate Services with OTC Markets Group. “The trading is in the biggest names, so if you have a stock that is not very liquid, the revenue isn’t there to write research. Yet, all of these companies are starved for coverage, starved for some base level of information that investors can use to properly analyze and trade their stock.”

This lack of incentives for investment bankers or broker/dealers to pay for small-cap research creates a vicious cycle that only further limits the growth of small-cap markets. Investors are wary of buying in because they can’t find enough research on a company, and there isn’t enough research on a company because investors are wary of buying.

Helping Investors Get the Data They Need

OTC Markets Group, which operates an Alternative Trading System (ATS) that connects a network of broker-dealers that trade nearly 10,000 securities, ranging from mega-cap European companies like Adidas (ADDYY), Heineken (HKHHY), and Samsung (SSNLF) to the tiniest of micro-cap stocks, has a clear stake in making changes to this system. With many of the companies trading on its markets suffering from this broken feedback loop, they have decided to take action to right the ship and help bring the sort of transparency and informed analysis to the micro-cap space that large- and mid-cap companies can take for granted.

The first step, announced earlier this year, was to begin offering quantitative equity ratings and research reports from Morningstar to its clients. Every company on OTC Markets Group’s OTCQX and OTCQB markets now receives a star rating from Morningstar based on their estimate of the stock’s fair market value. In addition, OTCQX companies and subscribing OTCQB companies receive Morningstar Quantitative Equity Research Reports that are updated daily and available for download and distribution to investors. The next step, unveiled just last month, was the new Research Marketplace.

“We started to think about what can we do so that we can at least get some base level of information on traders’ screens,” says Paltrowitz. “As trading becomes more quantitative, having that data available and having somebody publishing research based on that data that traders can use is so important. We started with Morningstar earlier this year, giving our QX companies a base Morningstar quantitative research package and star rating on their stock. This next phase, which we launched on September 19th, is what we're calling ‘The Research Marketplace.’ We've looked for some best-in-class providers, providers that we think add value and have good analysts. We want to put our companies in front of these providers so they can get additional coverage to what’s provided by Morningstar. These research reports provide a deep dive into a company by an analyst so that these companies have something they can use when they speak to investors.”

The result is a new portal on OTC Markets’ website where growing companies in need of more market visibility can go to shop for research firms that can tell their story.“It will have a positive effect on the market for smaller stocks,” says Peter Sidoti, Founder and CEO of Sidoti & Company, one of the three firms present in the marketplace at its initial rollout along with ACF Equity Research and Edison Group. “We are, by far, the largest independent provider of research in the small- and micro-cap industry, and we've been at it for 18 years and all we've done is provide research. So, as OTC markets moved ahead on this idea, I think we looked like the perfect partner from that side.”

Paid-for Research Fighting to Right its Reputation

Of course, anyone familiar with the reputation of paid-for research firms, let alone those operating in the small- and micro-cap space, would rightly raise an eyebrow at this point.

Addressing the conflict of interest that’s at the core of this relationship is a clear priority to making the final research report valuable to investors. When a company is paying for the production of a research report that it intends to use to bolster its share price, there’s a certain pressure on research firms to produce something that will make their clients happy. It’s precisely the sort of conflict that ultimately led to the dramatic failure of rating agencies that played a big role in the financial crash of 2009.

And the issue is even greater in the small- and micro-cap space, where a long history of bad actors has tainted the perception many investors have of the industry. Plenty of unscrupulous “research firms” over the years have written spurious reports just to prop up a client, or accepted stock as payment and turning their research reports into little more than a grossly transparent pump-and-dump scheme.

But that’s precisely why OTC Markets is stepping up with a service like the Research Marketplace. The hope is that, by rigorously vetting the firms it suggests to its companies, it can help them ensure that the research companies are paying for can be trusted by investors and will ultimately be meaningful to their efforts in building a quality shareholder base.

“The paid-for research market doesn’t have the best reputation,” says Paltrowitz. “Quite honestly, there’s a lot of bad actors, so we had a few criteria our providers had to meet. First and foremost, we would not work with anybody who accepted stock as payment. That was rule number one. The second thing we looked at is: are these companies regulated? So, of the three that we're starting with, one is an SEC-regulated FINRA member, and the other two are regulated out of the UK by the Financial Services Authority (FSA). The third criteria was editorial independence. If you look at the companies we have selected, all of them make clear that their research is unbiased. Companies can comment on the research, but in terms of the actual content, none of them allow clients to change what has been written.”

“Clearly, the company is paying and we make that known right up front, but we think that if you introduce these base levels of protections, it will ensure the research is more broadly used and more meaningful,” he continues.

Peter Sidoti was similarly adamant that, while the conflict of interest at the core of the relationship is clear, it can be addressed and mitigated through a commitment to transparency.

“We disclose what we got paid,” he says. “We know exactly where our conflicts are. Everyone understands it. We, as a firm, understand it. Our analysts understand it. Our clients understand it. We have an independent board which we think helps mitigate those conflicts. It’s something we are concerned about, so we admit it exists and put in a structure to deal with it.”

What’s more, assuming conflicts of interest don’t exist with other sources of research would likely be a mistake.

“Conflicts of interest have always been an issue on Wall Street, and they have always been an issue for research,” Sidoti continues. “We all know who Henry Blodget is. We all know what happened in 2008 or 2000, 2001. There has always been an issue that research has been run as a business. As a result, you have to assume some conflict - someone is paying for the product, for a reason other than the revenue that the research is generating. But for us, we've built a great brand, we've built a great distribution system and we have developed very solid reputations. The idea that we would put our whole business at risk for a small fee is kind of silly. We're just not going to do it.”

Building a Better Economy by Building a Better Microcap Market

The long term effects of this new resource won’t be known for some time. However, the potential for OTC Markets to continue growing the market for smaller public companies remains great. The perception that the small- and microcap space is too volatile and can’t be trusted has remained a persistent one, and one that hurts the ability for these companies to build on their initial successes.

“It has always amazed me, if you look at names like Valiant Pharmaceuticals (VRX), hundreds of millions of dollars has disappeared there. Peabody Energy (BTUUQ), a coal company that filed for bankruptcy, had a market capitalization of over $20 billion and lost almost all of that,” says Sidoti. “The amount of money that has been lost in the mid-cap arena far exceeds anything that has taken place in microcaps, but for some reason, microcaps tend to get much more attention, which I have never quite understood. You need more small companies; they are what drive the economy. Most job growth comes from small companies. But they need capital to grow and continue.”

By building more efficient and transparent markets and helping the right companies, those that are really creating jobs and powering innovation, grow their value and raise capital, OTC Markets could help create a space that bolsters the economy even as it’s enriching shareholders willing to take a chance.

“We’re creating a market that will give the small- or microcap company a fair shot at growth,” says Paltrowitz. “One day, those companies will hopefully graduate to the big boards and will be very successful. From where we were in 1997 to where we are now, I think the market has transformed significantly. But I still think there is work to do. Being able to raise capital, being able to get research coverage, being able to work with more broker-dealers and more clearing firms so that it's easier to deposit shares, all of that stuff is the future and, hopefully in five to 10 years, companies will find it easier being public.”

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