Movers and SHAKERS
Is Company Sponsored Research the Future for Small-Cap Stock Investors?
(Note: companies that could be impacted by the content of this article are listed at the base of the story [desktop version]. This article uses third-party references to provide a bullish, bearish, and balanced point of view; sources are listed after the Balanced section.)
Publicly traded companies are required to provide quarterly information to the public. This includes most categories of small-cap stocks and many micro-caps that are traded over-the-counter (OTC) trading on a regulated stock exchange. These SEC required reports provide a basis for investors to look back on company data. When financial data is compared to historical trends, weighed against industry growth and ratios, then subjected to “what-if” scenarios, the information becomes analysis. To qualify as research, the analysis is put under a spotlight along with evaluating the strength of management, intangible assets such as patents, market positioning, and a variety of other considerations.
Awareness of the investment opportunities these companies represent is typically low. Companies with a low market capitalization can benefit from any quality research published on their companies, their products, and their economic prospects. This is because any publication which provides a heightened understanding of a company may create interest that leads to added liquidity and aid to the market’s price discovery of the stocks’ best valuation.
In the past, small and micro-cap companies have benefited from coverage at research departments of broker/dealers who had the capacity to provide financial research. The motivation for these research departments to provide in-depth expensive research was often to act as a door opener for other lines of business (quid-pro-quo.) This introduces some risk of compromised integrity, the practice has been prevalent from sell-side research of public companies, of all sizes, for decades. A well-known example of how this could damage investors in a large well-known company is the collapse of Enron. The New York Times wrote: “Lawmakers investigating the collapse of Enron turned their attention to Wall Street today, criticizing financial analysts for continuing to urge investors to buy Enron stock even as the company headed toward bankruptcy. Several members of Congress suggested that Wall Street firms' hunger for investment banking business and other conflicts kept them from leveling with investors.” (NYT 2/27/02) The Wall Street Journal echoed this sentiment: “Some financial firms have said they felt obliged to participate in the partnerships in order to remain in the running for underwriting assignments from Enron.” (WSJ 2/8/02) “Complimentary” broker/dealer research of smaller companies pose a similar risk, however, when problems occur for investors, they are unlikely to get the attention of large news outlets.
From the point of view of some broker/dealers that provide complimentary research on behalf of less active companies, they are beginning to find the practice of not charging to do high-level research on these companies may cost more than the overall benefit derived. The quid-pro-quo, or “this for that” often does not have enough “that” to warrant “this” in their soft-dollar exchange. One overshadowing reason is the popularity of investment funds that are managed with the objective of providing returns mimicking a stock index. These indexed Mutual Funds (MF) and Exchange Traded Funds (ETF) provide close tracking of an equity index largely by owning the companies within the index. According to Morningstar, passive funds, those that mimic equity indexes, control $4.27 trillion in assets as of August 2019. This is a $1.36 trillion increase over the past 10 years. Others have reported the same dramatic shift of investment dollars differently. A CNBC headline from earlier this year shouted: “Passive investing automatically tracking indexes now controls nearly half the US stock market”. With half the U.S. Stock market now in passive money, there are fewer opportunities for broker/dealers to make soft-dollar income in return for “complimentary” research. Many have reallocated their resources in such a way to have prompted an evolution in where investors receive trusted, impartial, institutional-grade research reports.
The Evolution in Micro-Cap and Small-Cap Equity Research
Active research is still highly relied upon by those who transact in the micro-cap and small-cap sectors. As such, top-tier research coverage is crucial for small public companies looking to expand their visibility and investor interest in their companies. With fewer research firms covering them, there may not be enough investment interest for many of the future’s life-changing innovations to take root. Tomorrow’s life-saving drug, mining discovery, medical apparatus, or storage innovation may be denied to those who would have benefited from them.
Fortunately, there has been an evolution in how institution-level research is provided. The shift has small and micro-cap companies hiring respected research companies directly to provide an unbiased evaluation of their companies. This new practice eliminates the past conflict of interest of investment analysts who may have experienced pressure to err on the side of a favorable outlook to help smooth the way to additional higher-paying services from the client. A few of the research firms providing company-sponsored research to small-cap entities have taken an additional step. They are requiring their analysts to pass FINRA (Financial Industry Regulatory Authority) qualifying exams in order to become registered securities professionals. The exam(s) and ongoing continuing education required to maintain the professional registrations, ensure a high level of understanding, further promotes ethical behavior, and provides for punishment, including loss of career, if some guidelines are not adhered to.
The research firms that do require FINRA registered professionals are effectively pledging impartial presentation of the companies they are covering. This new standard in who provides research and who it is available to clearly benefits the sophisticated investor who always had access. But some firms providing company-sponsored research now make it available to all investors, of any size. This was most often not the case as sell-side broker/dealers often only allowed timely access to their buy-side customers.
Earlier this year OTC Markets and IR Magazine hosted an industry conference. During one of the sessions Jim Harvey, CFA® a portfolio manager and principal of The Royce Funds, a large, respected small and micro-cap fund company, was asked where he stands on company-sponsored research. His reply: “I’m not biased against company-sponsored research when it’s written by qualified, FINRA-licensed analysts.” It is now widely accepted that credibility and accountability can be combined by using FINRA registered analysts at company-sponsored research boutiques.
Noble Financial Group is a research-based investment bank. Their unique research report distribution platform is Channelchek. This provides company-sponsored research at no charge to investors. Noble’s FINRA registered analysts cover; healthcare, natural resources, transportation, technology, and media. Nico Pronk is CEO and President of Noble Financial Group While discussing the shift in providers of in-depth company research and the beneficiaries, Mr. Pronk explained: “Institutional-level research can now be more widely distributed to members of the investment community. In-depth, high-level research and analysis are being performed for small and micro-cap companies that may not have other business with our firm. We’re seeing this firsthand. We hold a conference early each year that brings investors and small innovative companies together. Our 16th annual Noblecon is drawing a lot more attention from financial professionals that include a greater percentage of sophisticated investors from independent investment advisors, large family offices, and even self-directed investors. We’re proud that our research product resonates so well with all of these groups.”
Looking Toward the New Decade
Investing goes through regular incarnations and reinventions. The use of technology has provided an environment where passive investing is gaining in popularity. Just as other trends of investing have fallen out of favor, disruption or innovation will one day turn the tide toward another trend. Fortunately, some of the research activities that have been dropped by the sell-side broker/dealers, effectively decreasing resources to their customers, have been replaced with boutique firms or a paid-for service. It’s arguably an improved system of company-sponsored research. This evolution is growing in appreciation by both those raising capital and those investing assets.
Author : Paul S. Hoffman