Why Do Investment Analysts Ignore Smaller-Cap Companies?

Ronald Woessner  |

Investment Analysts Typically Do Not Cover Smaller-Cap Illiquid Stocks

In my previous articles, I've discussed the issues driving the disappearance of small-cap public companies in the US market. Another example of the in-hospitability of the capital markets to smaller-cap companies is that investment analysts typically do not cover them.[1] According to a 2017 OTC markets survey, 68% of OTC issuers surveyed said they do not have any investment analyst coverage. Similarly, 62% of NASDAQ companies with market capitalizations under $50M do not have any investment analyst coverage.

This lack of investment analyst coverage negatively impacts these companies since academic studies have shown that when an analyst initiates coverage on an issuer its share price increases and its stock trading liquidity increases.

Keep in mind, there are two types of investment analysts: “buy-side” analysts and “sell-side” analysts. A buy-side analyst typically works for an investment fund/institutional investor and writes research reports on issuers whose stock the investment fund/institutional investor is considering purchasing. A sell-side analyst typically works for an investment banking firm and writes research reports on issuers who the analyst believes is an attractive investment opportunity. The report is then distributed to investment funds/institutional investors with the hope they will generate trading commissions for the investment banking firm by purchasing the stock of the issuer that is the subject of the research report.

This article focuses on sell-side analysts, as buy-side analysts do not distribute their reports.

So, why do so few sell-side investment analysts cover illiquid, smaller-cap company stocks?[2]

Because, as explained below, the analyst’s investment banking firm employer typically is not able to monetize a research report covering an illiquid, smaller-cap company.

The analyst's investment banking firm employer wants to reduce the "overhead expense" of the analyst by having the analyst generate revenue. Hence, the analyst provides the research report to various investment fund/institutional investors with the hope (expectation) that they will initiate a trade in the subject issuer and thereby generate trading commissions for the banking firm.

However, there are NO trading commissions to be made by the analyst's employer if the analyst's report covers an illiquid, smaller-cap company because, as explained in an earlier article, investment firms typically do not invest in illiquid, smaller-cap company stocks.

Since there is nil financial gain to the investment banking firm for the investment analyst to write a research report on smaller-cap companies, these research reports typically are not written. Rather, research reports ARE written on companies that have a higher likelihood of generating trading commissions, i.e., those with sufficient trading liquidity to attract investment firm capital.

It was said back in ancient times that “all roads lead to Rome.” For smaller-cap companies — all “roads" to attract investment firm capital require stock trading liquidity.

Naturally, an issuer wants to attract investment analysts to cover its stock to increase its stock trading liquidity and its stock price.

Beware: all investment analyst reports are NOT created equal!

Some say that the "buy" or "hold" recommendations issued by sell-side investment analysts are “skewed” to the positive for the purpose of pleasing the issuer about whom the analyst’s report is written. These critics note that approximately less than 7% of sell-side investment analyst ratings are “sell,” with the remainder being "buy" or "hold" or equivalent.

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According to these critics, the investment analyst’s employer (typically an investment banking firm) wants to be hired (or continue to be hired) to perform corporate finance activities for the issuer (raising capital, mergers & acquisitions, etc.). They posit that a company is less likely to do business with an investment banking firm whose investment analyst recommends “sell” on its stock. Common sense suggests they are correct.

On the other hand, SEC Regulation AC requires that an investment analyst certify that the views expressed in the report accurately reflect the analyst’s personal views. Hence, an investment analyst’s report presumptively is free of the skewed bias alleged by critics.

There is also a so-called "Chinese Wall" between an investment banking firm's investment analyst department and the firm's investment banking department to insulate the investment analysts from being influenced by the firm's investment banking activities.

Commentators have differing views as to the efficacy of these regulatory safeguards.

Academics have studied the efficacy of investment analyst research. These academics have divided sell-side investment analysts into four categories.[3] These four categories are:

Not surprisingly, the study concluded that reports of analysts in category (1) were perceived as more credible to investors than the reports of analysts in category (3) and, hence, were more effective in increasing the covered issuer's stock price and increasing the stock's trading liquidity.

The reports of analysts in category (3) typically are viewed skeptically because the investment banking firm employer had done corporate finance work for the covered company within the prior year (and likely collected a hefty fee). No surprise here.

NOTE: I am NOT saying to reject the offer of an investment analyst report in category (3). If an issuer has the chance to obtain an investment analyst report, typically the issuer should take it.[4]

What does surprise many is that the study concluded that research reports written by investment analysts in category (2) were equally as effective in increasing stock price and stock trading liquidity as the reports of the so-called "unbiased" investment analysts in category (1).

This study's conclusion is surprising to many because they have the preconception that reports written by analysts in category (2) will be viewed skeptically by investors because the issuer is paying for the report. For this reason, many CEOs and CFOs are hesitant to pay for investment analysts to write a report on their companies. In the face of this academic research, perhaps they should reconsider!

The research reports of firms in category (4) were determined to be equally as ineffective as the research reports in category (3).

There are several firms in category (2) who provide "paid for" investment analyst research reports. They can be located via Internet search. If you contact me through LinkedIn, I can introduce you to some I am aware of.

Next up: How does a company WITHOUT investment analyst coverage obtain such coverage? What can a company do to increase the trading liquidity of its stock? The next article discusses increasing your company's stock trading liquidity with the assistance of an investor relations firm.

© Ronald A. Woessner

December 27, 2018

Mr. Woessner mentors, advises, and raises capital for companies in the start-up and smaller-cap company ecosphere. He also advocates in Washington DC for policies that create a more hospitable public company environment for smaller-cap companies, enhance capital formation, support small business, promote entrepreneurship, and increase upward mobility for all Americans, particularly minorities. For more information on Mr. Woessner's background, see https://www.linkedin.com/in/ronald-woessner-3645041a/.

[1] This is a "truism" well-documented by a number of sources, including on pages 37 – 38 of the US Treasury 2017 Capital Markets Report available at this link.

[2] An investment analyst will often initiate coverage on a company for whom the analyst’s investment banking firm employer has raised capital or performed other corporate finance activity. As illuminated below, reports of these analysts are often viewed skeptically by investors.

[3] "The First Analyst Coverage of Neglected Stocks, Cem Demiroglu, Michael Ryngaert (2010). The study's conclusions appear on pages 555 – 558 and 581 – 582.

[4] The reasons are beyond the scope of this article.

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