By Small-Cap Institute, Inc.
One of the most impactful changes in the equity capital markets over the last few decades is the well-chronicled decrease in sell-side “research coverage” of smaller public companies.[i] For the regrettably large percentage of small-caps without such coverage, the question for their officers and directors is a notoriously vexing one: “Should we pay an independent firm to issue research reports on our company?” The goal of this piece is to provide unconflicted guidance to companies considering this issue.
The two advantages typically cited in favor of paying a research firm for coverage are increasing awareness, and publishing a financial model so that investors needn’t construct one from scratch. These are reasonable goals. Here are some practical ways to assess their achievability.
The traditional route. Small-caps are often capital constrained, therefore, prior to paying for research it makes sense for companies to assess whether “unpaid” research is potentially forthcoming.
- Do any substantially similar peer companies have research coverage? If so, have you engaged in any discussions with those firms or analysts?
- Are there equity research analysts who cover companies with capital markets profiles that your company could realistically achieve in the near to medium term? If so, have you engaged in any discussions with those firms or analysts?
- Does your company envision accessing the equity capital markets for growth capital? If so, have any of the investment banks under consideration provided research coverage to companies similar to yours?
Highly technical companies. The more technical your company, the more important it is that the analyst responsible for covering your company has expertise in what your company does. Even if the research firm you’re considering has a good reputation, the actual report is only as good as the analyst primarily responsible for producing it. Don’t ever hire a firm without speaking with the covering analyst(s) and gauging their expertise for yourself.
Conflict of interest. As was evident in the aftermath of the Financial Crisis, issuer-paid research comes with an unavoidable conflict of interest. While it can be managed, it’s important to be frank in this regard: Independent research firms that are paid by issuers know that they risk the vibrancy of their businesses by routinely speaking critically of those companies. So, when considering an independent research firm, explore the firm’s recent body of research to determine whether the published reports are intellectually balanced or… not. If an independent firm has ratings like buy, sell or hold, are all of the reports “strong buys?” If they have price targets, are all of the targets substantially higher than where each stock is trading today? If a firm with uniformly positive research says that their reports are all positive because they only agree to write research on high performing companies, has the diligence they’ve conducted on your company borne out that intellectual rigor?
The moral of the story is simple, but too often overlooked: If investors all know that independent firm ABC issues a glowing research report – devoid of any constructive analysis – on any company that can afford their fee, you need to think carefully about how impactful the research report is going to be.
Beware the “distribution” myth. When it comes to content like research, distribution – or readership – is important. You can have a great piece of research, but it’s not going to be effectual if no one reads it. That said, some independent research firms espouse dramatic distribution statistics for their research that are certainly challenging to verify. So, when you’re considering a paid research firm, reach out directly to the audience that matters most – smart, experienced investors. Ask them one question, and listen carefully to the answer: “If you received an analyst report from [analyst name] from [research firm] about a company like ours, would you take the time to read it?” If a meaningful sample of seasoned investors respond “no,” then query whether it matters how many of them are on the mailing list.
From an investor: “When I own a name that is not widely followed, I am interested in any research coverage of that company, whether paid-for or sell-side, as I’m eager to learn more. On the other hand, outside of sell-side coverage from a larger investment bank or a specialized firm with recognized industry experts, I tend to lump the majority of coverage into one bucket. It’s fairly clear to investors when research was written simply to check a box. Anyone can cut/paste text and data from a company’s website into a Word document and hit ‘send.’ Research reports require actual analysis for them to be worth reading. And to make the research really actionable, it needs to come from someone who is willing to ask hard questions about the company, which is why most investors tend to get their research from… other investors.”
Track record. When in doubt in the capital markets, be a student of precedent more than a consumer of marketing. Randomly select four or five initiation reports from the research firm under consideration that date back a couple of years ago. Compare what’s written in those research reports to what’s transpired since they were published. There is no such thing as an analyst who always gets it right, but there is such a thing as an analyst who rarely gets it right.
Lots of sell-side equity research is, of course, “paid” with investment banking fees. And there are certainly conflicts of interest in that ecosystem as well. Accordingly, some point out that it’s a bit naïve to think independent, issuer-paid research is that much different than investment bank research.
It’s also naïve, though, to ignore the reputational issues associated with some small-cap independent research firms, and the regard in which some of it is held by seasoned investors.
Under the right circumstances, paid research can not only achieve the goals set forth above, but it also broadens the availability of content regarding underfollowed small-cap companies. But you need to ask research firms and investors hard questions, listen carefully to the answers, and adjust your expectations accordingly.
[i] Several factors have led to the decrease of sell-side research coverage in small-cap companies. They include, but are not limited to: (1) the decimalization of stock prices; (2) a consolidation of small-cap broker dealers; and (3) the revised Markets in Financial Instruments Directive (also called “MiFID II”). Small-Cap Institute, Inc. will cover these subjects in greater detail in future articles.