Analyst Asymmetry

New York–Integrity’s recent analysis of small-cap research highlights the severe shortage of analyst coverage for smaller-cap companies.  Integrity’s research reveals that half of all publicly traded companies have 2 or fewer analysts, and 65% have fewer than three analysts, whereas analyst coverage is highly concentrated on large cap stocks, which average 17 analysts per stock.

In fact, the median analyst coverage figure for companies with a market cap below $500m is 0, while the mean is 1.  According to Reuters, approximately 1,200 of NASDAQ’s 3,200 listed companies and 35% of all public companies have no research coverage whatsoever. Between 2002 and 2005, 691 companies lost analyst coverage, representing over 17% of the entire universe of companies with analyst coverage. Furthermore, 97% of companies without analyst coverage have a market cap under $1 billion.

Yet another analyst covering Google or GE is hardly likely to provide the market with any truly new information; nevertheless, as we can see from the graph below, a tiny number of companies with large market caps receive an overwhelming share of analyst attention:



This trend has only gotten worse recently. Integrity’s interviews with money managers who focus on small-cap stocks have revealed that the quality and availability of small-cap research from large sell-side firms has fallen significantly in recent years. Many analysts at these firms tend to ignore small-caps, even though these are precisely the companies where they can provide the most additional value to investors.

Academic studies support the notion that companies which receive adequate analyst coverage face a significantly lower cost of capital. In 2004, Bowen, Chen, and Cheng tested the theory that analyst coverage “can reduce information asymmetry among investors and thus lower the cost of raising equity capital.” Since there is limited direct evidence on this topic, they studied a sample of 4,766 seasoned equity offerings (SEOs) in the period 1984-2000, and the “overall results suggest that analyst coverage significantly reduces SEO underpricing. Compared with firms without analyst coverage, firms with the median level of analyst coverage – three analysts – have a 1.19% lower SEO underpricing, a relative decrease of 38%…  In sum, we provide direct evidence consistent with analyst coverage reducing information asymmetry and lowering the cost of raising equity capital.” Furthermore, according to Chan and Hameed (2003), greater analyst coverage increases stock price synchronicity with the market. Thus, we can expect that the majority of publicly traded companies which lack adequate analyst coverage will suffer from a higher cost of capital, unnecessary volatility, and generally inefficient pricing.

Equity research teams that under-emphasize coverage of small-cap stocks are missing an enormous opportunity to provide investors with valuable and profitable information. Nevertheless, there are a number of investment banks and independent research firms that provide reliable and high-quality coverage of the universe of small-cap stocks. Integrity’s upcoming ResearchFocus report on Small Cap Research will evaluate the best sources of research in this underserved section of the market.