Oogling Google

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New York-How many analysts are needed to cover Google?  Admittedly, it’s one of the sexiest stocks out there with a market cap approaching $170 billion (larger than the GDP of Singapore or Israel, and closing in on Hong Kong’s GDP).  But really, does it require over 35 analysts to follow this stock?

We hear from asset manager clients pleas for assistance in finding small cap research.  There many under-covered stocks, and money managers know there is value in researching them.  As an aside, in the debate about the relative performance of large cap stocks versus small caps, there is not enough attention paid to the fact that small caps have a structural advantage-the inefficiency of the market in valuing small caps which is exacerbated by the persistent under-coverage of the small cap sector.

So why the herd mentality with a stock like Google?  Mostly it reflects the popularity of the stock with institutional and individual investors.  Most research departments feel they would lose mind share by not covering it.  For the analysts it is like playing the lottery-the chances of coming up with something original on Google are minute but the payoff is large.

But mostly the crowd of Google analysts reflects the old fire hose business model for research.  Blast it out and hope you get commissions in return.  Continued unbundling of research commissions from execution will generate market mechanisms for aligning the supply of research with demand.  If there is an oversupply of Google analysts, prices paid will go down.  The best thing for Cox would be to follow through on what was promised over a year ago-better commission transparency guidelines.  This would provide support to market forces which are clearly still nascent-as evidenced by the supply/demand imbalances in the research market.

Here is the roster of analysts following Google.   The list is incomplete because Sanford Bernstein recently initiated coverage (?!) and because there are a few firms such as Merrill which refuse to distribute their research through Thomson which is the source of the list.

Barry, Stewart of Thinkequity Partners

Becker, Robert of Argus Research Corp.

Bolan, Brian of Jackson Securities

Brown, Derek of Cantor Fitzgerald

Chowdhry, Trip of Global Equities Research

Devitt, Scott of Stifel Nicolaus & Company, Inc.

Faber, Hamilton of Atlantic Equities

Friedland, James of Cowen And Company

Garcia, Denise of A. G. Edwards & Sons, Inc.

Greenwald, Todd of Nollenberger Capital Partners

Jain, Pratik of First Global Stockbroking Ltd.

Khan, Imran of J.P. Morgan

Mahaney, Mark of Citigroup

Martin, Laura of Soleil – Media Metrics

Mastin, Troy of William Blair & Company, L.L.C.

May, Mark of Needham & Company

Moran, Clayton of Stanford Group Company

Morrison, William of JMP Securities

Munster, Gene of Piper Jaffray

Noto, Anthony of Goldman Sachs

Peck, Robert of Bear Stearns

Pitz, Brian of Banc Of America Securities

Pyykkonen, Martin of Global Crown Capital

Quarles, Christa of Thomas Weisel Partners

Rohan, Jordan of RBC Capital Markets

Sanderson, Rob of American Technology Research

Schachter, Benjamin of UBS

Squali, Youssef of Jefferies & Co.

Terry, Heath of Credit Suisse

Weinstein, Steve of Pacific Crest Securities

Westerfield, Leland of BMO Capital Markets

Wolk, Marianne of Susquehanna Financial Group

Comment by Bill George:
Sandy, I enjoyed your ResearchWatch article today “Oogling Google”.

As I read the article a number of thoughts came to my mind. I think some of my thoughts help to further explain the extreme imbalance of research coverage with the bias toward the “over-coverage” of large capitalization stocks (like Google).

I believe one very important factor contributing to the imbalance of research coverage of large cap growth stocks is the liquidity of these securities. Large capitalization stocks allow portfolio managers to invest in statistically significant dollar positions in a security, and be somewhat confident that their individual purchases and sales of the security will not have significant market impact.

This large cap trading liquidity allows portfolio managers to maintain a manageable number of total positions, but it also increases the risk that any one position, or a small number of positions, will drastically influence portfolio returns. So the manager becomes much more news and research sensitive, hence the portfolio manager will constantly try to gather more information on these holdings (put a few eggs in the basket and watch them very closely). The portfolio manager will gladly use clients’ brokerage commission dollars to buy the research “lottery ticket” described in your metaphor.

Also, you mention how the herd mentality effects sell-side research, but you didn’t mention how it influences the portfolio management (buy-side) of the street. I believe large institutional fund portfolio managers are very reluctant to take pioneering positions on securities. For portfolio managers and buy-side analysts, the risk of being wrong on a uniquely held position far exceeds the rewards from being right. In performance measurement “outliers” are treated with suspicion and skepticism. An institutional portfolio manager can usually maintain his / her mandate as long as he / she maintains portfolio returns near the median of all institutionally managed portfolios. Bottom quartile managers loose their mandate, top quartile managers are assumed to be exposing portfolios to higher risk and are very closely scrutinized. The lesson: Be a closet indexer.

Alternatively, small capitalization portfolio managers attempting to avoid the negative consequences resulting from market impact of trading illiquid stocks and the negative consequences of bad stock selection, resulting from information inefficiencies in small capitalization stocks, are forced to hold a large number of positions to avoid any one position producing drastically negative consequences. Again, the result of this approach to portfolio construction is for institutional small capitalization managers’ portfolio returns to cluster around the median of all small cap managers’ portfolios.

Would additional research on small cap stocks encourage small cap managers to decrease the number of “positions” in their portfolios? I doubt it. Small cap stocks are inherently more risky because of their capital structures, management skills, and the small cap bias toward emerging product / service offerings. They are more likely to experience uneven revenue flows and more likely to fail as business ventures, therefore it makes more sense to diversify a small cap portfolio toward a larger number of holdings. Of course, as the number of small cap positions increases the small cap portfolio returns look more and more like a small cap index.

Another thought that came to mind, the increased institutionalization of the market has increased this group-think effect and increased institutional capitals’ risk sensitivity / aversion. I believe this institutionalized risk averseness may be one of the factors that has contributed to the significant growth, and changes in structure, of venture capital, PIPES, hedge fund, and private equity investing. Professionals who can convincingly argue a case for accepting greater risk, can efficiently convince pools of capital to use the above structures as vehicles for controlling and moderating the risk and for harvesting alpha opportunities created by institutionalized risk aversion and the inefficiencies created by informational imbalances (i.e. the lack of publicly available, inexpensive, small-cap research).

Another, somewhat interesting side-note about the volume and effectiveness of full-service brokers’ research coverage might be that the number of sell-side analysts covering individual stocks like Enron, WorldCom, Web-Van, Global Crossing, NorthPoint Communications, Kozmo, JDS Uniphase, XO Communications, Kibu, CoVad Communications, etc. was longer than the list of research analyst’s covering the stock mentioned in your article. And in each case this preponderance of analysis didn’t provide much valuable insight into the future fortunes of these companies before they imploded. Further, it seems that the role of sell side analysts in the context of sell side-investment banking and initial public offerings must always be questioned, no matter how many “Chinese walls” regulators attempt to put in place. It seems to me a lesson from past experiences is that the market must always question the effectiveness, and the motives of sell-side brokerage research. Sell-side analysts can sense what managements’ goals are without a memo, if these analysts don’t “get it” they don’t last long.

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