New York, NY – Readers of Integrity’s ResearchWatch blog are well aware of our concern with the state of the small cap stock research business. Over the past six or seven years, research coverage of small and micro cap companies in the U.S. has plunged as the economics of the business has changed dramatically. However, as this has taken place, a number of entrepreneurs have stepped up to try and address the systemic problems inherent in the small cap research business. Most of these efforts have not been terribly successful. Unfortunately, a few weeks ago, one of the more commercially successful small cap research firms, JM Dutton, became the latest victim of the difficult market environment.
Dutton Closes up Shop
JM Dutton, a research provider with close to 120 US and UK small and micro cap companies under coverage, closed its doors as the current market environment prompted smaller public companies to reign in their efforts to obtain research coverage. Consequently, Dutton’s 18 analysts – most of whom have decades of sell-side or buy-side research experience – have found themselves out of work.
Dutton’s business model was to charge companies between $30,000 to $40,000 per year to produce and distribute high quality investment research to buy-side and high net worth investors. Due to the fact that many investment banks have been scaling back their small cap research coverage in recent years, a number of small and micro cap companies have opted to pay for research coverage rather than going without.
The “paid for” research model has been disparaged by many as being highly conflicted since corporate issuers have considerable commercial leverage over the research firms that cover them. Consequently, many argue that issuer sponsored research is likely to be overly optimistic. This however has not stopped small research boutiques from adopting this business model. According to Integrity’s proprietary database, approximately 44 firms in the U.S. accept payments from corporate issuers to provide research coverage on them.
Dutton, however, has been one of the few “paid for” research providers who has willingly subjected their research recommendations to be tracked by third-party research performance systems. For many years, Dutton’s research did extremely well according to these systems, consistently outperforming a large number of sell-side and alternative research providers. Despite the performance of their research, Dutton found it quite difficult to overcome the many challenges associated with the small cap research business.
Not the First, Nor the Last to Be Shuttered
Dutton is not the first, nor will they be the last, small cap research firm forced to close their doors. One of the more high profile endeavors to shutter their operations was the Independent Research Network, a joint venture founded in August 2005 between Reuters and NASDAQ to promote research coverage for under covered companies.
The IRN was established to intermediate the inherent conflicts that arise from the paid-for business model. The IRN planned to stand in the middle of the transaction between the research provider and the company, providing the payment mechanism, the communication channel and any dispute resolution services that might be required. Companies would be assigned three research firms to review and monitor that company for a set fee per year. Unfortunately, this model did not gain much traction, leading to its winding down in September 2007.
The initial rationale for the founding of the Independent Research Network made considerable sense. As a result, other firms also started up to try and solve the problems that small cap companies face in getting research coverage. In May of 2005, former Vice Chairman of NASDAQ, David Weild IV founded the National Research Exchange to provide “intermediated research”. IRN executives Daniel Blank and O’Hara Macken, founded Bright Meridian in October of 2006 to broker relationships between public companies and sell-side research firms. Unfortunately, neither the NRE nor Bright Meridian fared much better than the IRN.
Dearth of Small Cap Research Coverage
Today, close to 50% of all public companies have no research coverage at all, while at least 75% of all firms are under covered (defined as having less than 3 analysts covering these companies). As a result, these public companies suffer a discount in their stock price that can directly be attributed to their lack of research coverage.
Unfortunately, given the economics of the small cap equity market, combined with the pressure most investment banks and brokerage firms are facing today, it is highly unlikely that small and micro cap companies will find it easier to get sell-side research coverage in the future. The struggles faced by most buy-side firms are also likely to impact alternative research firms in 2009. Consequently, we doubt that small cap companies will get any real boost in coverage from alternative research firms either – particularly if other firms like JM Dutton are forced to shutter their doors.