What small caps can do to make the search for sell-side coverage easier.
by David Calusdian
Investor relations officers of micro and small-cap companies often hear a common question from their CEOs and CFOs: “Why can’t we get sell-side coverage?” Of course, for a sub $500 million market cap company, obtaining analyst coverage can seem more difficult than finding the Holy Grail, climbing Mount Everest, and solving the world’s energy crisis – all in the same weekend, In fact, for many companies, getting covered by even one sell-side analyst can be a highly challenging – and frustrating – endeavor.
Certainly, management expectations regarding the sell side can be dramatically misaligned with the reality of the financial markets today. Long gone are the days – if they ever existed – when good financial performance and an interesting growth story were all that it took to attract analyst attention.
Why coverage is So Difficult
So why is obtaining sell-side coverage so difficult today? Not surprisingly, it all comes down to profitability, and the business model of the modern sell-side firm. Investment banks do not directly make money from research coverage, It’s actually a cost center for these firms.
How does the system works? Sell-side firm are paid in “soft dollars” from their buy-side clients through trading commissions. Those fees have been decreasing since trading commissions were deregulated in the late 1970s, and particularly since the advent of decimalization. In 2001, the Securities and Exchange Commission required that Securities prices be quoted in decimal increments versus the historical fraction method. This change reduced the buy/sell spreads and, in turn, the profits that investment banks made on trades
As commissions decrease, it takes a higher share of trading volumes for a sell-side firm to make money on particular stocks and defray the cost of issuing research coverage. Therefore, it becomes inherently more difficult for small-cap companies with limited trading activity to gain coverage.
One potential solution is to expand the buy/sell spreads for small-cap companies. In June 2014, the SEC announced a proposal to implement 12-month pilot program to widen the trading increments for certain small-cap companies SEC Chair Mary Joe White said, “It is time for a careful assessment of the impact of decimalization on our equity market structure and the interests of investors and issuers“. The SEC recognizes the impact of decimalization on the markets and listed “market maker profitability” as one potential benefit from the so-called “Tick Size Pilot Plan”.
In 2003, the Global Research Analyst Settlement was intended to separate the linkage between research coverage and investment banking. And certainly, some say that the settlement has been a factor in the reduction of sell side coverage, especially for small caps. With the separtion of banking from coverage, sell-side firms would not be incentivized to provide research on companies they are courting for banking business.
Of course, newly public companies nearly Always end up being covered by the banks that manage the deal. It also is rare not to see the disclaimer at the end of an analyst’s research note stating that “this firm expects to receive or intends to seek investment banking related compensation from the company”. So in reality, unless unless they are newly public, small caps find it difficult to obtain coverage if they are not involved in investment banking deals.
At the same time, investment banks have been managing the new research cost environment by having their analysts each cover a larger number of companies, making them increasingly time constrained. As a result, for a director of research at an investment bank to decide to dedicate resurces to covering a particular company, he or she needs to have a high level of confidence in the potential for a positive return on investment.
Evaluate Your Coverage Viability
So what’s a small-cap company to do with the deck stacked against it from a number of different angles? First, do a company analysis to evaluate your chances for sell-side coverage. Ask yourself a number of relevant questions. How high is your trading volume? Is it only 50,000 or even 10,000 shares a day? If so, your liquidity will be a significant obstacle to obtaining coverage. As you get closer to 100,000 shares traded a day, you’re nearing the ballpark.
Look at your company’s recent performance and its growth prospects. Analysts seek to cover companies that have performed consistently well, and have the opportunity to exibit further short-term and long-term growth and stock appreciation. The analyst’s goal will be to pick up coverage of the company and recommend it to their buy-side clients prior to the next stock uptick.
In addition, be sure to consider whether the company has missed its own guidance in the past year or the expectations of the few analysts who may already follow it. Analyst do not want to be embarrassed by companies that perennially miss their estimates, and will shy away from those that cannot be trusted to meet expectations in this area.
Finally, look beyond your specific company and determine whether you are in a “hot” sector that would interest analysts and their buy-side clients. For example, a company that stands to benefit from the trend toward 3D printing or is in the value stream for the next version of the iPhone stands a far better chance of gaining coverage than a slow-growth manufacturer of a commodity product.
After you have a good understanding of your company’s positive and negative factors, start proactively communicating with sell-side targets. For a small cap-company, it is more likely that you will find success with small regional or boutique firms. They often are more open to picking up coverage on an underfollowed growth company than covering a large cap with 17 other analysts – all trying to differentiate their research and fighting over commission table scraps.
Evaluate the boutique and regional sell-side firms that follows other small-cap companies in your space. Those firms may have a higher propensity to cover your company given their familiarity with your market. Keep in mind, however, that these firms may only be following your peers because of past investment banking relationships. For example, the bank may have initiated coverage after managing the IPO or brokering an acquisition.
You also need to make it exceptionally easy for analysts to follow your company. First and foremost, provide them with access to management. If a prospective analyst requests a meeting with your CEO and is made to wait a month for face time, you probably have missed an opportunity.
Also be attentive in providing any prospective analysts with all of the information they need to conduct their due diligence. And in doing so, make sure they have an excellent understanding of the company’s investment thesis and catalysts for near-term stock appreciation. Remember, in the end, analysts are looking for ways to make money for their clients and increase their firm’s trading commissions. No stock appreciation catalysts = no commissions = no coverage.
Finally, offer to go on the road with them to meet with their buy-side clients, even before they pick up coverage. Remember that corporate access is extremely important to their financial model.
Going on the road before they initiate coverage demonstrates your willingness to meet their clients on an ongoing basis. In addition, assuming the Analyst you are targeting accaompanies you on the road, he or she will be able to hear your story, listen to the questions posed to you by investors, and get a sense of the buy side’s interest in your company.
Life Without the Sell Side
There is no silver bullet to obtaining sell-side coverage, especially for a small-cap company. Very often, the economic model of the modern sell-side firm is at odds with the company’s financial characteristics. If you find that the challenge of obtaining sell-side coverage is insurmontable, remember that the sell side is only a means to an end – and that “end” is visibility with the buy side.
When there is no sell side to serve as a counduit to shareholders and prospective investors, enhance your outreach to the buy-side. Conduct your own investor targeting and schedule road shows each quarter on your own. Many under-covered and uncovered small-cap companies have been very successful in building visibility with the investment community and enhancing shareholder value by taking their message directly to investors.
Of course, in addition to the challenging task of gaining sell-side coverage and communicating directly to the buy side, investor relations officers also must manage the often-unrealistic expectations of their management and board. Educate them on sell-side economics and the steps that small cap-companies can take to obtain coverage. Then, start searching for that Holy Grail.
This article, already published on IR Update, is posted with the express permission of NIRI and David Calusdian.