Small Cap Analyst Coverage: an "Under-The-Radar" Dilemma

Author Name: 
Justin Canivet

For years thousands of companies around the world have been operating outside analyst radar. As of January 31, 2009 there were over 46,000 companies listed on WFE member exchanges worldwide[1]. Add to that the thousands of companies that trade on non-member exchanges and regulated OTC markets, and you have an extremely large population of publicly traded companies all vying for analyst attention. With this many companies listing and trading on global equity markets, sell-side analysts need to be selective when it comes to providing research coverage. As a result, Forefactor conservatively estimates that 35 – 40% of all publicly traded companies worldwide have no sell-side analyst coverage. For WFE Member exchanges, that means over 16,000 companies are potentially “off the grid” or “under-the-radar”. Unfortunately, it is the smaller, less liquid companies that tend to slip through the cracks. More heavily traded, large-cap companies attract greater sell-side analyst attention for three primary reasons:

  1. Large-caps are more likely to generate higher investment banking fees;
  2. Typically, greater liquidity translates into higher revenue from trading commissions; and
  3. Many buy-side funds are bound by market cap restrictions on portfolio holdings.

Consequently there is less incentive from a broker-dealer perspective to provide coverage for small and micro-cap companies.

Compounding this issue is the noted decline in the size of the sell-side research community. Forefactor estimates that the number of sell-side analysts is down approximately 25 – 30% since 2000, and predicts that with fewer analysts, research from the sell-side will increasingly focus on the large-cap sector leaving more and more companies without the benefits of coverage. Anecdotal evidence and experience also tells us that there is an increasing lack of investor confidence in the use of price targets and investment recommendations – particularly for small and micro-cap companies. Further, Commission Sharing Agreements (CSAs) are allowing the buy-side to unbundle commission dollars and allocate the research portion of those dollars to the advisory firms that add the most value. All of these changes have translated into greater demand for new equity research alternatives.

The advent and increasing number of “independent” research firms has served to help decrease the climbing number of uncovered companies. Without the influence of proprietary trading desks and investment banking operations, these research-only firms claim they can provide a truly unbiased research product – for a fee. However, Forefactor estimates that only a small fraction of companies have opted to pay for this type of coverage.

Absent analyst research, the only remaining option for companies is to publish their own corporate fact sheets, and although this is common practice, it is often met with investor skepticism as companies have much to gain from publishing a positive review.

Retail investors and professional money managers are faced with an enormous amount of market information on a daily basis and the common perception is that companies with little or no analyst coverage are simply not worthy of attention. Lack of analyst coverage impacts liquidity and has a negative effect on company valuation. However, with coverage, even if only from one analyst, companies become more visible, investors show more interest, there is typically a boost in liquidity, spreads tighten and valuations improve. Exchanges are in the best position to remedy the issues associated with no analyst coverage. They have the opportunity to facilitate positive market impact while increasing Issuer satisfaction and offsetting pressures on existing revenue streams.

Increasing competition and challenging economic conditions are putting significant stress on traditional exchange business models. Most notably, trading revenue is declining. According to the investment banking community, a downswing in volume is the result of multiple factors, including:

  1. Investors have become increasingly risk averse and are diversifying into “safer” investments (flight-to-quality);
  2. Funds have greatly de-leveraged their portfolios;
  3. Portfolio values have dropped due to substantial losses; and
  4. There are fewer buy-side players due to bankruptcy filings.

In addition to the above pressures on trading fee revenue for exchanges, broker internalization is a contributor as it affords efficiency and fee reduction for both investors and dealers. Lastly, Alternative Trading Systems (ATS’) continue to gain market share. All of these factors have contributed to intense volatility and dramatic volume fluctuations for WFE Member exchanges (while the number of equity trades in February 2009 was up 35.6% over February 2008, the number of equity trades in January 2009 was down 16.8% compared to January 2008 ). Even as market confidence returns, Forefactor anticipates that new buy-side risk tolerances will moderate trading activity and continuing competition for market share will sustain lower trading fees.

Additionally, exchanges’ data revenue streams may be burdened by the ATS’ that offer market information and historical data for free.

Based on the aforementioned market transformation, Forefactor’s hypothesis is that future revenue growth for traditional exchanges will be driven by four things: listings, diversification into multi-asset class businesses, asset-backed investments (e.g. real estate), and proprietary products (e.g. ETFs).

In 2003 Forefactor’s principals identified that a gap in research coverage existed, particularly for small and micro-cap companies. It was also discovered that some companies were feeling “under-serviced” by their respective exchanges – that being listed was considered a cost rather than a benefit. Our theory was that some exchanges were focusing a disproportionate amount of attention on driving revenue growth from trading and market data instead of taking a more balanced approach and providing added support for Issuers. It was this theory that served as the catalyst for providing third-party, exchange-sponsored research coverage for companies with no analyst following. Since then the concept has evolved. Forefactor has added new elements of company analysis and has developed a business model that eliminates the potential for conflict of interest and adds a revenue generating model for participating exchanges.

Forefactor firmly believes that third-party, exchange-sponsored research will add value and increase loyalty among listed Issuers. The integration of knowledge from deep exchange industry experience and discussions with industry experts on the buy-side, has resulted in a research product that accurately reflects the needs of both Issuers and investors. Forefactor’s Financial Factsheets (F3 Reports) are based 100% on factual information but are far from ordinary factsheets. In addition to a full company review, including a breakdown of market performance, capital structure, financial statements, core assets, and management composition, each report contains an Altman Z-Score calculation as well as a comprehensive peer analysis covering a wide range of financial and market indicators. The Altman Z-Score is calculated using a financial model developed in the 1960’s by a professor of finance named Edward Altman. For the last 40 years, this model has been highly accurate in measuring the financial stability of public companies. “The Z-score has up to a 95 percent accuracy rate in predicting bankruptcy based on data from approximately one year prior to failure.” Scores are calculated using a formula combining five widely-used financial ratios. Higher Z scores indicate positive financial health and lower scores indicate financial stress. The result is an objective measure for benchmarking a company’s financial condition against that of its sector peers.

Market participants agree that the ability to access the aforementioned content in one comprehensive piece of due diligence increases efficiency, addresses a gap in the marketplace, and adds value to their daily process.

Under Forefactor’s proposed partnership model, participating exchanges will provide marketing support and facilitate Issuer subscription. This allows Forefactor to remain at “arm’s length” from all companies being covered thus eliminating any potential for conflict of interest. It also provides exchanges the opportunity to benefit both strategically and financially. Strategically, exchanges will increase Issuer loyalty, attract new listings and provide an innovative marketing tool that will raise awareness for public companies and their associated exchanges. Financially, Exchanges may choose to add a new revenue stream by charging Issuers for the administration of the F3 research program. Furthermore, increasing the visibility on lesser-known companies may augment or at least buttress the decline in trading activity and perhaps offset larger losses in trading revenue for Exchanges.

Exchanges and their Issuers are the foundation upon which capital markets and economies are built. Any effort to increase visibility and improve liquidity for “under-followed” public companies is critical to restoring market confidence and stimulating economic recovery.

About Justin Canivet

Justin is a financial markets professional with over 13 years experience in a variety of different capital markets disciplines including portfolio accounting and custody banking, equity research, portfolio management, investor relations, and corporate strategy and development. Prior to joining Forefactor, Justin worked for over 5 years with TSX Group where his responsibilities included; monitoring the competitive landscape in the global exchange/ATS/trading technology space (both cash & derivatives markets); helping define the strategic direction of the company; providing research support for business case development, and identifying and evaluating relevant M&A targets. Prior to TSX Group, Justin held analyst positions at Sceptre Investment Counsel, Yorkton Securities, and State Street Trust Company Canada.

Justin holds an Honours Bachelor of Arts Degree in Economics and was awarded the Chartered Financial Analyst designation in 2000. He has been a member in good standing of the CFA Institute, and the Toronto Society of Financial Analysts (TSFA) since 1999.