Sell-Side Equity Research Coverage: Clarifying Persistent CEO Misconceptions

7 minute read

Sell-Side Equity Research Coverage: Clarifying Persistent CEO Misconceptions


One of the least understood aspects of shepherding a small-cap company is garnering and maintaining sell-side equity research coverage.  The goal of this piece is to clear up commonly-held misconceptions.

Attracting coverage

Economics.  One of the main reasons why there are so many persistent misunderstandings about research coverage is that most small-cap leaders don’t sufficiently understand how analysts make money.  Succinctly, the business case for equity research coverage is: (1) recommend to clients – institutional investors – that they either buy or sell a particular stock; and (2) get paid a percentage of the trading commissions that result when institutional investors subsequently buy or sell the recommended stock through their firm’s trading desk.

Why the economics are integral to coverage.  Each equity research analyst and their team of institutional sales people – those who attempt to interest institutional investors in the analyst’s recommendations – is focused upon a fairly discrete subset of institutional investors.  Analysts typically publish the stocks they “cover,” and that “coverage universe” makes it quite clear what kinds of stocks their clients are interested in.  For example, an analyst might cover semiconductor companies with a median market capitalization of $750m.  If your semiconductor company has a market cap of $45m, our hypothetical analyst’s clients are far less likely to have an interest in your company; i.e., analysts only make money by making timely, accurate recommendations on the kinds of stocks their clients want to buy.

Trading volume.  Analyst’s only make money on the variable portion of their compensation if their clients buy and sell recommended stocks through their firm’s trading desk.  If your stock doesn’t trade sufficient volume for an analyst’s clients to be able to buy or sell a full position size, then the investors will be foreclosed from buying and selling your stock, and analysts won’t make any money from the recommendation. 

Small-cap CEOs waste inordinate amounts of time trying to convince equity research analysts to cover their stock, when illiquidity in their stock prohibits any chance of coverage.  Put differently, you could have the greatest company in the world, but if an analyst’s clients can’t buy or sell adequate amounts of your stock, then research won’t be forthcoming.  To determine whether your company has adequate liquidity for a given analyst, simply calculate the median daily dollar trading volume – the average amount of shares traded per day multiplied by the average closing price – of the analyst’s coverage universe.

Value of a given analyst’s coverage.  All small-cap equity research coverage is definitely not created equal.  Most small-cap CEOs fail to realize that only a small fraction of small-cap equity research coverage is held in high regard by experienced retail and institutional investors.  CEOs can avoid wasting a lot of time and money, by simply asking experienced investors in your industry which research analysts they actually care about.  Seasoned investors are constantly amazed at how few CEOs actually do this.  To be blunt in this regard, the lion’s share of small-cap equity research coverage, whether paid or unpaid, isn’t value added and goes completely unread by the majority of investors.  Veteran small-cap CEOs know to completely disregard investment banking marketing hyperbole, and simply ask investors directly.

Desperate disclosures.  Many small-cap CEOs, often under pressure from board members who aren’t capital markets-savvy, will do anything to attract research coverage.  An astonishing number of small-cap CEOs violate Regulation FD when speaking to analysts, either because they don’t understand the law, or because they think the unlawful disclosures will cajole (positive) research coverage.  When CEOs disclose material, non-public information to high-quality equity research analysts, two things happen, and both are bad: (1) analysts will make a mental note that the CEO is either reckless or a bad actor; and (2) those perceptions are likely to make their way to high quality investors.  Memo to CEOs: (1) learn Reg. FD from counsel, and don’t ever violate it; (2) always remember that analysts and investors who appear to be fine with unlawful disclosures are people you should stay away from.

Stalking.  Even if your company is a great fit for a well-regarded analyst’s coverage universe, there is a difference between persistence… and stalking.  Analysts are people – smart people – and they are highly attuned to CEOs who display poor judgment.  Learn who the highly-regarded analysts are in your industry, and endeavor to keep them appropriately apprised of your story and progress.  Be smart, and leave it at that.

Metrics.  Veteran research analysts know the power they wield, and they know that most small-cap CEOs – particularly inexperienced ones – will be highly responsive to analyst interest.  Seasoned analysts often take advantage of their influence to induce CEOs to overshare.  Interacting with research analysts is a constant chess match: analysts want as much lawful information as possible, and CEOs should be cautious about disclosing new business metrics/KPIs that could either aid competitors or mislead investors.  CEOs, in concert with their boards and service providers, need to determine the metrics they believe are appropriate to disclose, and then CEOs need to resist the temptation to exceed those disclosures to appease highly inquisitive analysts.   

Maintaining coverage

They are NOT your friends.  Easily the biggest mistake made by small-cap CEOs when interacting with analysts who have buy recommendations on their stock, is that they come to view positively-inclined analysts as friends of theirs or the company’s.  Neither could be further from the truth.  Analysts are paid to recommend profitable trades for their clients – it doesn’t matter to them whether those trades involve buying your stock… or selling your stock.  That is, an analyst that is bullish about your company’s prospects, will be bearish – literally a moment later – if they believe your stock is likelier to go down versus up.  When CEOs erroneously think of analysts as “friends,” they are going to exercise poor judgment with them at some point; it’s not a matter of if, but when.  The moral of the story is: CEOs must always maintain an even-keeled, arm’s length relationship with each and every equity research analyst and their sales people.  Bulls become bears, and bears become bulls; smart CEOs treat all equally, all the time.

Analyst days.  Responding to periodic inquiries from analysts can become highly disruptive for CEOs, particularly once there are several equity research analysts covering a company.  Convening periodic meetings at company headquarters – or other appropriate sites – for the benefit of all sell-side analysts accomplishes two important objectives: (1) it ensures that analysts are receiving the same information (with no duplication of efforts); and (2) it sends a message to the Street that the company values its sell-side relationships and is as transparent as possible with them.

Commenting on coverage.  The best general rule of thumb for CEOs – subject to advice of counsel – is not to comment on the recommendations contained in sell-side equity research reports.  There is little upside to the commentary, and plenty of downside.  For example, if a CEO singles out a particular research report to disagree with, should investors assume that the CEO is fine with the recommendations contained in other research reports they’ve elected not to comment upon?

When coverage ends

What comes around, goes around.  The earlier admonition about maintaining an even-keeled comportment towards equity research analysts also applies when coverage is discontinued.  An analyst’s coverage wasn’t personal when it was initiated, and it’s equally unlikely to be personal when discontinued.  Accordingly, CEOs should treat such decisions with courtesy and respect, particularly since many analysts change firms and might cover the company anew in conjunction with a future investment banking role.  The other reason why it’s a terrible idea for CEOs to react negatively when coverage is discontinued is, because all the other analysts are watching your conduct.

Make it a learning experience.  Analysts are often very astute observers of the strengths and weaknesses of CEOs and corporate storytelling.  Though not all of them will entertain such requests, it can be a great use of time to meet with an analyst after they’ve discontinued coverage to learn what the company – or the CEO – could improve upon going forwards.