Small Cap Battle of the Bulge

New York – Integrity is assessing the value of small cap equity research firms. When analyzing firms that cover small cap firms, there are a number of research providers that cover mostly small caps, such as the regional and/or boutique investment banks, a short list of alternative research providers that cover the space and a number of alternative research providers that cover the space using a paid-for model. However, in discussions with small cap research users, a number of bulge bracket firms came up repeatedly. Indeed, from a customers’ point of view, it is not relevant who produces the research, but who adds value in the research process. Even so, the bulge bracket is a different animal that the other small cap research, in that they cover a large number of stocks and are not sector specific.

As a result, we began thinking about the value added of the bulge bracket firms in the small cap space. Fortunately, we have 3 years of Investars data on the Russell 2000 and S&P 500 index coverage of the research firms Investars tracks. Ordinarily, small cap researchers are compared to their bogey–namely the Russell 2000. To assess the marginal contribution of the small cap portfolio research (or small cap analysts) at the bulge bracket firms compared to the large cap portfolio research (or large cap analysts), we compared the Russell 2000 Investars return with the S&P 500 return for the bulge bracket firms. The table below details these returns and compares them to the excess return of the Russell over the S&P which could have been expected over the 3 year period.

Index and Investment Bank Returns in Annual Percentage Change
August 2004 to August 2006

Russell 2000 S&P 500 R – S
3 Year Return 13.82% 9.15% 4.67%
Selected Bulge Bracket
Citigroup 29.03% 9.63% 19.40%
Merrill Lynch 24.60 11.84 12.76
UBS 9.05 5.04 4.02
Bank of America 7.99 6.88 1.11
Wachovia 5.20 2.58 2.62
Bear Stearns 3.49 2.09 1.40
Credit Suisse 2.32 3.15 -0.83
Morgan Stanley 1.93 2.71 -0.77
Deutsche Bank -0.13 4.35 -4.48
JP Morgan -4.17 2.60 -6.77
Goldman Sachs -5.96 3.36 -9.32

The selected bulge bracket firms have been ranked by their Russell 2000 returns. Alongside these returns are the returns they achieved in their S&P 500 stocks. The final column is the difference between the Russell 2000 returns and the S&P 500 returns. At the top of the table is the expected excess return that would have been generated by a passive long position in both indexes over the 3 year time frame.

Clearly, many of the bulge bracket firms have an expertise in small caps. Small cap analysts at two firms provided greater than expected excess returns in the small cap space–Citigroup and Merrill Lynch.

Note: The data for this blog is from Investars, the analysis tabular presentation and conclusions are those of Integrity Research Associates.


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