Reforming Small Cap Coverage

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Kudos to Tim Keating for proposing reforms to improve analyst coverage of small cap stocks.  In an article in Pension & Investments, he expands on his recent white paper by proposing that emerging growth company status under the JOBS Act be applied to equivalent public companies, in addition to his earlier suggestions for increased tick sizes for small cap stocks and the elimination of the quiet period for equity research for all IPOs.

Keating Capital is a publicly traded Business Development Company (or BDC) that specializes in making pre-IPO investments in emerging growth companies.  Earlier this year Keating published a white paper, Analyzing the Analysts: A Survey of the State of Wall Street Equity Research 10 Years after the Global Settlement, which examined the impact of the Settlement on research as well as Institutional Investor rankings and the tiered research services offered by bulge bracket firms.  The paper did excellent job explaining equity research’s structural bias toward large cap research.

His P&I article reiterates the sparse coverage of small caps:  “As of Dec. 31, 2012, out of 5,044 exchange-listed companies, 1,443 had no meaningful analyst coverage of their stocks. That figure represents nearly 29% of all companies listed on major exchanges.”

Keating’s primary proposal is for increased tick sizes on small caps to compensate broker/dealers for covering small caps:

But with commissions compressed and trading spreads decimated by market reforms in 1997 and 1998, and the advent of decimalization in 2001, Wall Street has no economic incentive to staff up the sales, trading and research desks to cover these smaller public companies, and that’s bad for everyone. A simple solution would be a program that permits tick sizes (the minimum trading size for stocks) of 5 cents, 10 cents and 25 cents for smaller stocks.

Combined with the elimination of the quiet period for equity research and the application of emerging growth company status to existing public companies that qualify, larger tick sizes would improve the small-cap IPO market, according to Keating.

The problem with this argument is that it doesn’t address a key factor in decline of small cap IPOs: the increasing use of ETF’s and other passive vehicles.  Individual investors are vital to any resurgence to the small cap IPO market since most institutional investors focus on large and mid cap stocks.  Yet, as Keating admits, “Individual investors are much more likely now to own model-generated portfolios of index-tracking mutual funds and exchange-traded funds than individual stocks.”  Increased tick sizes gives incentives to the suppliers of small caps, but doesn’t create demand for small caps.

As commissions sag, equity research is headed for major structural changes. Lower commission spending will not support the current level of equity research resources, whether at the bulge firms or mid-tier brokers or small independent boutiques.  The result is a slow, painful process of consolidation.

Small caps have already suffered declining coverage and will suffer more as regional brokers downsize, merge and/or go under.   Keating’s proposals would provide incentives for small cap brokers to hang in there longer.  Given the strong bias toward large cap coverage, counter-balancing incentives make sense.  Nevertheless, the proposals do not address the shift of assets to ETFs and other passive vehicles which is the root cause of moribund IPO markets and declining commissions.

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